By longstanding tradition, local phone companies are required to sell their services to customers at roughly comparable prices. (1) This so-called "universal service" obligation is intended to ensure that people who live in rural and residential areas (which are expensive to serve) can buy phone service on terms similar to those offered to urban or business customers (which are cheaper to serve). (2) Under universal service obligations, then, retail pricing is typically averaged across a variety of customers or geographic areas.
The Telecommunications Act of 1996 ("Telecom Act" or "1996 Act"), (3) however, introduced a new wrinkle into the realm of telecommunications pricing. By law, local telephone companies, known as incumbent local exchange companies ("ILECs"), would be forced to lease virtually all of their equipment and facilities to their competitors, the idea being that the competitors could then offer a competitive product to the consumers. (4) The pricing terms of such leases are to be set by state public utility commissions, who must calculate the theoretical cost of constructing a new network. This system of cost-based pricing is known as TELRIC, which stands for "total element long-run incremental cost." (5)
While this idea may have had merit standing alone, (6) the combination of universal service obligations and cost-based wholesale leasing is utterly perverse. It simply makes no sense to require the same company to sell its wholesale access at cost, while it must still sell its retail services to all customers at an average price that completely ignores cost. (7) As the California energy crisis of 2001 showed in painful detail, it is absolutely unworkable to attempt to keep below-cost retail regulation in place while creating a system of at-cost wholesale prices. (8) The predictable result in California was to "drive the utilities to the point of insolvency." (9) Some analysts predict a similarly gloomy future for the telecom industry. (10)
The following analogy might be instructive: Imagine that Ford had historically been seen as a monopoly provider of automobiles. Imagine further that because of a desire for fairness to all customers, the government had traditionally required Ford to personally deliver cars to all customers' homes at roughly the same price, even if some customers were located right next door to a dealership while others lived a hundred miles from any dealership. This system might be workable as long as Ford was able to use its monopoly power to charge all customers a similar price, such that the next-door customers were essentially subsidizing the far-off customers' delivery.
But then suppose that the government, in an effort to undermine Ford's historic monopoly, ordered Ford to sell all of its automobiles at wholesale, cost-based prices to Chevrolet, who could then relabel the automobiles and resell them immediately. The result would be easy to predict: Chevrolet would buy Ford's autos at the cheap, wholesale prices, and would then target the next-door customers who had historically been relatively overcharged. This, in turn, would undermine Ford's ability to comply with the obligation to deliver automobiles at average prices to rural customers far away from the dealership.
Current telecommunications regulation is roughly equivalent to this hypothetical I have sketched. Local phone companies are being forced simultaneously to provide service at averaged prices to expensive rural customers and to sell wholesale access at cost to their competitors, who can then resell phone service to urban and business customers. This in turn undermines the local phone companies' ability to comply with universal service obligations.
To put things more clearly, here is a simplified model of telecommunications service. Imagine that a state consists of 50,000 urban business customers, 50,000 suburban residential customers, and 10,000 rural customers, all of whom purchase exactly the same service package. …