Region Focus

Winter 2003


Conquering the Divide
By Al Broaddus
Federal Reserve Bank of Richmond

This issue of Region Focus examines some of the recent developments in the telecommunications industry. The growth of the Internet, the development of high-speed, high-capacity transmission technology, and the regulatory changes included in the 1996 Telecommunications Act all contributed to a frenzied pace of infrastructure investment. The gold rush came to an end, however, when industry participants came to realize that investment in capacity had advanced well ahead of growth in demand. While this boom-bust cycle may have been the most conspicuous development in the sector, apparent disparities in "access" to the new communications infrastructure have also received increasing attention. Many observers have noted a growing "digital divide" between technological "haves" in affluent urban communities and "have-nots" in small and remote rural locations. Similar concerns have arisen at some point in the history of virtually every network communications industry in the United States, from the post office to local telephone service and even interbank payment systems like check clearing. These concerns have often been at the heart of government interventions in these markets.

The motivation for intervention comes from certain technological features common to all network communications industries. A significant part of the cost of connecting a community to the wider national network is independent of the number of users in the community. As a consequence, the average cost per user falls as the number of users goes up. This creates a challenge for small, remote communities. The average cost of serving their citizens is higher — sometimes far higher — than the cost of connecting users in more populous and centrally located areas.

Historically, political pressures have driven network industries to compensate for cost disparities across communities via price structures that have high-cost users cross-subsidizing low-cost users. A classic example of such a structure is the uniform nationwide price for first-class postage, independent of the location of the sender or the receiver. Another example, in the days of regulated rate-setting, was the typical structure of telephone service rates, where it was common for services to households to be subsidized by business users.

The trouble with subsidized rate-setting is that it is incompatible with competition. If there is easy entry by competitive suppliers, then the customers paying a subsidy (low-cost customers) will be attractive targets for "cherry-picking" by competitors. The implementation of price structures with cross-subsidies has, therefore, usually required limits to competition. Ever since deregulation in telecommunications (via the 1996 act), there has been an attempt to preserve subsidies for some high-cost users. For example, customers of local telephone services pay a surcharge that defrays some of the costs of providing high-tech communications services to rural schools and hospitals.

A very different approach to the problem of access for remote locations is highlighted in our story on "going the extra mile." That story tells of the decision by Bristol, Va., to fund its connection to the broadband infrastructure through a public bond issue, without outside rate-regulation subsidies. Bristol made a collective community decision regarding the common costs and benefits of making this investment, independently of decisions about the provision and pricing of services to users in other locations. This is how markets should work, since no distortion is imposed on the prices paid or choices made by other users. Indeed, in a world of rapidly changing technology, regulatory restrictions on who can provide what services have become increasingly difficult to sustain. As a result, subsidized pricing becomes untenable. What remains is the approach taken by Bristol. Hence, while smaller, more remote communities sometimes are thought to lag in the adoption of new technology, this particular community may in fact be leading the way to a new answer to the age-old question of network access.

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