Optimal Pricing of Local Telephone Service

Although payment for nearly all other goods and services, including toll (long distance) telephone calls, increases with greater consumption, nearly 90 percent of the residential telephone subscribers and more than half the business subscribers in the United States now pay a flat monthly rate for local calls (see Larry Garfinkel). Recently, however, the telephone companies and regulatory commissions have been moving cautiously toward imposing usage charges for local telephone calls. There is renewed interest in what is currently termed "usage-sensitive pricing"t (USP). It is due to the combined forces of inflation, increased local usage, and competition from independent firms that sell telephone terminal equipment and supply private toll lines to business customers. Under USP, the pricing of such services as telephone installation, directory assistance, and minutes of calling is based on incremental rather than average costs. Since World War II, technological advances have benefited long distance far more than local telephone calling. Development in microwave communications, coaxial cable, satellites, and waveguides have dramatically lowered the costs of long distance transmission. In contrast, the costs of local service have moved upward since the late 1960's at a rate not far below the general price index (see AT&T, 1975). Faced with a continuing stream of requests for local telephone rate increases, state regulatory commissions are finding the concept of tying prices to usage increasingly attractive. AT&T and some of the independent telephone carriers are beginning to test USP plans in several cities. With flat rate tariffs, increases in local calling add to carrier costs but not to their revenues. The local calling rate per subscriber has increased by an average of 2 percent for the past seven years. AT&T's chairman has stated, "We are moving more and more in the direction of usage-sensitive pricing" (see Washington Star News, p. A12), and according to newspaper accounts of AT&T management documents, the Bell System plans to phase out flat rate telephone service and begin charging for each local call in major metropolitan areas in 1978-80 (see Seattle PostIntelligencer, pp. 1, 10). Still, regulatory commissions, consumer groups, and the carriers themselves remain cautious about requiring usage-sensitive tariffs for all subscribers. The prospective gains from prices more closely related to costs are at least partially offset by the added costs of metering equipment and billing. Most telephone subscribers prefer flat rates, according to Bell System marketing surveys (see Garfinkel, p. 28). And it is by no means clear which groups of subscribers will be helped and which harmed by such revisions in local tariff structures. Will the poor end up paying more because they use their phones more? Should different prices be charged for calls at different times of day? On what bases should the monthly and per call rates be determined? The purpose of this paper is to sort out some of the questions of economic efficiency and equity that arise when changes are considered in the methods of pricing local telephone services. In Section I, I construct a * Department of economics, The Rand Corporation, and the International Institute of Management, Berlin. This study was supported under a grant from the John and Mary R.. Markle Foundation. I am indebted to Walter S. Baer for numerous contributions to this paper, to S. C. Littlechild and Patricia Munch, and to the managing editor and a referee of this Review for critical and constructive review of a draft. I have benefited as well from the comments and suggestions of James H. Alleman, Stanley M. Besen, William S. Comanor, John M. Drew, Leland L. Johnson, John A. Kay, Edward D. Lowry, Carl Pavarini, John Rolph, Ralph Turvey, and Chris Witze. Bryant Mori assisted with the computer programming. See my 1976 paper for a more extensive version of this paper, which also discusses optimal flat rate and optimal peak load tariffs.