Trillion Dollar Economists_How Economists and Their Ideas have Transformed Business

by Robert Litan

  Regulators traditionally had several ways of countering these tendencies, none ideal. One approach, as noted, is to carefully scrutinize operating and fixed costs, which has its limits. Another approach, which Elizabeth Bailey (highlighted in Chapter 9) documented in her PhD thesis, is the byproduct of the regulatory process itself known as “regulatory lag.”29 Because regulated firms must seek approval for the price they plan to charge in the future based on the costs and investments they have made in the past, lags are an inherent part of the regulatory process. These lags can also work to the regulators’ advantage, since any unanticipated costs that the firms experience in a current period cannot be partially or fully recovered until a future period, assuming regulators permit this to happen. This introduces some uncertainty into the process, which should encourage the regulated firms to exercise some caution in incurring expenses, a tendency that may offset any laxness toward cost control induced by cost of service rate regulation.30

  Even regulatory lags are not ideal for encouraging efficiency, however, because regulated firms always have an informational advantage relative to their regulators, who then tend to defer to the firms on the legitimacy of their expenses. Couple this with the gold-plating incentives for excessive investment built into regulation and you can understand why economists and regulators began to look for better ways to encourage regulated firms to be more efficient.

  The answer, beginning in the 1980s, came in the form of “incentive regulation,” a broad term that covers a range of devices for incentivizing regulated firms to control costs. Perhaps the best known of these alternatives is “price cap” regulation, in which regulators limit the price of the firm’s service at or close to last year’s costs, generally with adjustments upward for inflation and downward for an assumed level of productivity improvement, typically based on industry-wide experience. Stephen Littlechild, a British academic economist who also was a regulator (like Alfred Kahn in the United States), was instrumental in developing this formula.31 Price caps can be and often are reset every several years to establish a new base level, in light of recent historical experience. Research has shown that price cap regulation in telecommunications has encouraged productivity improvements.32

  Price caps are not perfect, however, since they entail two very different sorts of potential problems. On the one hand, if they are too binding, they may induce the regulated firm to cut corners in serving customers in order to reduce costs and keep profits up. There is evidence that this has occurred to some degree among telecommunication firms in the United States.33 Regulators can offset some tendencies for service-quality deterioration by including service-performance measures (such as outages, customer complaints, and so on) in setting the caps, as electricity regulators have done in the United Kingdom and in Massachusetts in this country.34 On the other hand, if the caps are not sufficiently tight, they allow the regulated firm to earn higher profits—at the expense of consumers—than it would under a system of rate of return regulation.

  For these reasons, two leading microeconomists who pioneered some of the best thinking about incentive regulation (among other topics), Jean-Jacques Laffont and Jean Tirole, suggested in the mid-1980s that regulators are best served by giving regulated utilities a menu of options, including not only price caps but also profit-sharing schemes that enable consumers and even employees to share in the additional profits that efficient regulated firms might achieve, or conversely share in the shortfalls that those firms may experience if they are not as efficient or productive as a specific price cap might imply.35 In fact, as various researchers have noted, a version of profit sharing was used in the United Kingdom in the late nineteenth and early twentieth centuries in the regulation of manufactured gas, but was essentially ignored by U.S. electricity and telephone regulators in the early twentieth century, who adopted cost of service methods instead.36

  As it has turned out, although some form of incentive regulation of utility prices is now widely used in United States and elsewhere around the world, few regulators have adopted the menu idea. Instead, utility regulators, those overseeing telecommunications firms in particular, prefer either caps with productivity adjustments or some version of the profit- or earnings-sharing idea promoted by Laffont and Tirole and others.37 These alternatives seem to be superior to rate-of-return methods in balancing the needs of regulated firms to raise capital to support continued investment, on the one hand, and the welfare of consumers purchasing their services, on the other.38

  Economists and Spectrum Allocation

  From the days of Adam Smith in the late eighteenth century, economists were writing about and singing the praises of markets and prices for efficiently allocating resources. So if anything, it was a surprise that it took a couple of decades after the federal government began handing out spectrum licenses for the first economist to suggest that there was a better way: auctioning them. That economist was Ronald Coase, who also wrote a number of other path-breaking articles, for which he was awarded the Nobel Prize in 1991 (see following box).

  Ronald Coase: The “English” Economist

  In a social science where mathematic agility is increasingly prized, Ronald Coase was an amazing exception. He eschewed math in his published work and spoke to his readers in crystal-clear English.

  Coase was born in Great Britain, earned his doctorate in economics at the University of London, and came to the United States after World War II. He taught, successively, at the Universities of Buffalo, Virginia, and Chicago.

  Coase was one of those individuals who wrote sparingly, but when he did, some of the products were blockbusters. As one biography of him put it, in his long career—he died in 2013 at the age of 102—he published only “about a dozen” papers using little or no mathematics, or what he called “blackboard economics.”39 But two of those articles earned him the Nobel Prize in 1991.

  In the first of those papers, written in the late 1930s when he was 27, he wondered how capitalists could decry state ownership of firms in such socialist countries as Russia, when the U.S. economy hosted such large industrial giants (then) as General Motors and Ford. His answer came in a now famous article “The Nature of the Firm,” in which he analogized firms to centrally planned economies with one important difference: Firms in capitalist economies are formed out of choice, and specifically out of the inspiration and hard work of their founder-entrepreneurs.40 What determines the scale of a firm, Coase posited, is the relative benefits and costs of conducting transactions with people and suppliers inside the firm and thus outside of a market, compared with doing the same thing in a market setting at arm’s length with third parties. Firms exist, then, because at least for the activities conducted inside them, it is more cost effective to transact within the firm than using markets.

  Coase’s second great article, written 23 years later in 1960, addresses the “Problem of Social Cost.” The article provides a novel market-based solution to the problem of externalities, such as pollution which, up to that time, economists thought could only be corrected with government intervention—taxation or regulation—to correct a “market failure.” Not so, Coase argued. If it was costless, or at least very inexpensive, for parties to bargain, it wouldn’t matter which party, the polluter or pollution victim, had a property right because the cheapest solution from a societal perspective would be reached through bargaining by the parties. If the victims had the right not to suffer pollution, the polluter could compensate them. Conversely, if the polluter had the right to pollute, the victims could pay to make it stop. Either transaction would take place only if it was in the best interest of society as a whole.41

  Coase had a famous debate with free-market legend Milton Friedman—who initially contested what has since been called the “Coase theorem”—at the home of Chicago economist Aaron Director, at which he persuaded all those attending of the correctness of his insight. In the real world, however, where polluters or creators of externalities may be relatively few in number, those affected ar
e much more numerous. So the costs of organizing all those involved to engage in a Coasian “negotiation” can be prohibitively high. In this likely typical situation, most economists believe that some kind of government involvement is appropriate, provided the cost of “government failure” is not greater than the cost of “market failure.”42

  Of immediate relevance to this chapter, Coase was the first economist to make the case for auctioning scarce public goods, such as licenses to portions of the electromagnetic spectrum. He did this in 1959.43 As three economists (including Nobel laureate Vernon Smith) have put it, Coase’s proposal at the time was “mocked by communications policy experts, opposed by industry experts, and ridiculed by policy makers.” Today auctions are the standard way the commission allocates spectrum. Since Congress adopted the idea in 1993 and through 2010, the FCC had held 73 auctions, selling over 27,000 licenses, and generating over $50 billion for the U.S. Treasury.44

  As noted in the box, Coase suggested spectrum auctions in 1959. It took Congress more than three decades to adopt the idea. Economists played significant roles both in designing the auctions, and also helping some of the companies bidding in them.

  Auctioning licenses to transmit and carry wireless voice and data signals in each of almost 50 geographic markets, which policy makers ultimately wanted to link together in nationwide networks, is a lot more complicated than auctioning a single piece of art or other scarce collectible. It is more expensive and less helpful to consumers if ownership of the licenses is fragmented among many parties, each having to interconnect with the other. At the same time, policy makers did not want the mobile telephony market to be dominated by just one or two carriers; they wanted vigorous competition among several of them, not just to better serve consumers but also to maximize the revenue earned by the government in selling the licenses.

  Various economists had ideas for how the commission could best achieve these apparently conflicting objectives, but none were as influential as Paul Milgrom (see following box), his colleague Robert Wilson, and longtime senior economic advisor at the FCC Evan Kwerel, who was put in charge of auction design by the commission.

  The key mechanism these economists designed was the simultaneous auction that required bidders to remain active in every round of bidding in order to be eligible to receive any licenses at the end. The auction ends when no more new bids in any market are submitted. The procedure thus described differs from a market-by-market auction, which allows individual bidders to pick off certain markets with high bids, but gives no incentive to any of them to bid in other markets.

  Paul Milgrom: Auction Designer

  While Ronald Coase deserves the credit for coming up with the idea for auctioning spectrum, Paul Milgrom deserves most of the credit for designing the auctions themselves, along with his thesis adviser Robert Wilson.45

  The difference between the concept and implementation also is reflected in the very different kind of research that Coase and Milgrom published. Whereas Coase was a man of words, Milgrom’s work is highly mathematical, but also highly useful.

  After earning his undergraduate degree in mathematics from the University of Michigan, Milgrom spent several years applying his education as an actuary, before returning to the academy to earn his master’s degree in statistics and Stanford, where he also gained his PhD in business.

  Milgrom since has taught at three universities: Northwestern, Yale, and Stanford, where he has spent most of his professional career, combining his research and interest in auctions with game theory. His work in designing auctions has been applied in the United States and other countries not only in telecommunications, but also in electricity and natural gas. Milgrom has also advised various firms on auction strategy and various public bodies, in addition to the FCC, in the United States and other countries.

  As of this writing, in 2014, the FCC is preparing to auction by mid-2015 additional low-frequency spectrum (below one gigahertz) for wireless purposes, especially for broadband communications. Designing these auctions has been an unusual challenge, but once this latest round of auctions is complete, it should significantly expand wireless broadband capacity and speeds.

  Unlike earlier auctions where the FCC marked off a portion of the spectrum that was not previously being used or was easily reallocated away from other purposes, most of the spectrum being auctioned this time has been held by television broadcasters that must be induced to give it up (much of the rest is held by the Departments of Commerce and Defense, which have to release it for commercial purposes). As a result, the commission must approach the 2015 auctions in two steps: first, by holding a “reverse auction,” where broadcasters bid the minimum price they are willing accept for their licensed spectrum, which determines how much revenue the FCC has to share with the broadcasters. Only with sufficient participation by the broadcasters will the FCC be in a position to proceed to the second stage of the auction, selling the spectrum given up to wireless broadband providers.

  Another complication of the purely private sector incentive auction is whether, or to what extent, the commission is going to allow the two largest mobile providers, AT&T and Verizon, to participate in the second stage of the auction. Not surprisingly, smaller competitors do not want the commission to allow these two mobile giants into the auction, or at least to place tight limits on the fraction of the population they could serve with new licenses. The two large carriers, in contrast, argue that the scale economies of serving a nationwide market, coupled with the additional revenue that their active bidding will most likely generate for the federal government, are two strong reasons why they should be allowed to bid without restrictions. In addition, even if they won most or all of the auctioned low-frequency spectrum, existing licensees of low-frequency spectrum would still be able to compete without any significant impairment, so competition in mobile broadband would continue to be healthy.46

  At this writing, it is not clear whether the FCC will restrict any firm from bidding. One factor in its decision will be the extent to which it wants to maximize auction revenue for the government. Depriving or limiting AT&T and Verizon from bidding would reduce federal revenue, both for deficit reduction and for funding the build out of a better first responder network that was authorized in the 2012 legislation that instructed the commission to proceed with the latest auctions.

  Economists will play an important role in these auctions, as they have before. Within the FCC, economists helped design both stages of the auction. Outside the FCC, economists surely will assist various bidders to navigate their way through the auctions. It is difficult to think of a government activity where economists have been such an important part of the process, from conception to implementation.

  The Bottom Line

  It can be easy to forget or ignore the role of economists in a technology-intensive industry such as telecommunications, where engineers and technologists rule the roost. Nonetheless, all firms in any industry must abide by the rules of the road set by policy makers: legislators, regulators, and judges. Those actors, in turn, are often highly influenced by the ideas of economists. This could not be more evident than in the telecommunications industry.

  For a long time, monopoly and scarcity were the watchwords in telecoms. AT&T dominated telephone service, locally and throughout the nation. The federal government, as steward for the electromagnetic spectrum, handled the spectrum’s scarcity by overseeing an administrative system of licensing that also constrained competition. Economists, aided by technological advances, helped persuade policy makers to undo monopolies where possible, so when economies of scale still required monopoly firms, the government could regulate them more effectively and respond to the scarcity of spectrum in nontraditional ways.

  Economists played a critical role in designing and implementing the legal action that ultimately unwound AT&T’s control over not just telephone service, but also the equipment used to provide it. In doing so, economists helped pave the way for the investments in the physical infras
tructure that later became the backbone of one of the great technologies and business platforms of the modern era, the Internet.

  Local telephony and other utility services are still regulated at the state level and economists have had important impacts here, too, helping to shift price regulation away from reimbursing costs, guaranteeing a reasonable profit on investments in physical plants and equipment, and toward regulatory systems that provide incentives for cost control. Although not perfect (no system of price regulation can be), incentive-based approaches are generally regarded to serve the interests of consumers better than the prior rate-of-return systems they replaced.

  Last but not least, economists have been prime movers behind the idea that spectrum for mobile communications should be auctioned, and how those auctions are structured. In addition, economists have been essential advisers to the firms participating in the auctions.

  In short, it is no overstatement to claim that the modern Internet-based business landscape of today owes much of its shape, if not existence, to the behind-the-scenes thoughts and research of numerous economists. Keynes’ aphorism about “practical men” being slaves to some defunct (and mostly still very much alive) economists could not be better validated than in the telecommunications industry and the many firms that have been built on its platforms.

  Notes

  1. Quotation attributed to George Dyson in James Fallows, “The 50 Greatest Breakthroughs since the Wheel,” The Atlantic, September 2013, 56–68. This section also draws on a similar history of telecommunications in Robert E. Litan and Hal J. Singer, The Need for Speed: A New Framework for Telecommunications Policy for the 21st Century (Washington, DC: Brookings Institution Press, 2013).