Telephone company entry into cable television: A re-evaluation

Telephone company entry into cable television

Even If all legal entry barriers were eliminated, telephone companies would face dim prospects for competing with cable televlslon operators In the transport of video services, at least during thls decade. This situation arises because the economic characterlstlcs of flbre-based Integrated broadband networks of Interest to telephone com- panles are not promlslng. Unless the demand for switched video Is strong, households will continue to be served separately by cable television networks and by swltched narrowband networks durlng the 1990s.

Leland Johnson is a senior economist with the RAND Corporation, 1700 Main Street, Santa Monica,. CA 90407, USA (Tel: 310 393 0411). At the time this studv was underway,’ David Reed was a RAND con- sultant and a doctoral candidate in the Department of Engineering and Public Policy, Carnegie Mellon University, Pitts- burgh, PA. He is now a telecommunications policy analyst with the Office of Plans and Policy, Federal Communications Commission, Washington. DC 20554. USA (Tel: 202 653 5940).

Research for this article was supported under grants to RAND from the Markle Foundation and Richard S. Leghorn. The views expressed here are solely those of the authors and do not necessarily reflect the opinions or policies of the sponsors of RAND research.

‘Department of Trade and Industry, Com- petiiion and Choice: Telecommu&cations Pclicv for the 7990s. HMSO, London, March 1991; Office of Telecommunica- tions, Statement, Competition and Choice: Telecommunications Policy for the 199Os, London, 5 March 1991.

122

An evaluation

Leland L. Johnson and David P. Reed

Much debate has focused on whether telephone companies (local exchange carriers) should be permitted to offer television services within their telephone service territories in competition with cable television operators. On one hand, competition might be expected to reduce prices and improve service. On the other, many assert that telephone companies would be able to compete uneconomically by subsidizing video services at the expense of their telephone subscribers. The debate is further complicated by rapid technological advances that pose new opportunities - and uncertainties. Especially, telephone companies are expressing strong interest in the development of integrated broadband networks (IBNs) that would combine video, voice and data services on a single fibre-optic network.

In the USA the Federal Communications Commission (FCC) adopted in 1970 a cross-ownership rule that generally prohibits telephone companies from providing video services within their operating territories. This prohibition arose from fears that telephone companies (a) would restrict access to their poles and conduits needed by their cable competitors, and (b) might shift costs of video service to their telephone customers, enabling them to cut prices for video service and to drive out or discourage entry by cable television operators.

In 1988 the FCC tentatively concluded that the public interest would be better served by dropping the cross-ownership restrictions, on the grounds that access to poles and conduits is now a much less serious problem and that competition between telephone and cable television operators would tend to reduce prices and encourage new services. However, the FCC has taken no further formal action.

In the UK public telecommunications operators (PTOs) such as British Telecom have not been permitted to provide entertainment services on their own networks. In early 1991 a stipulation was added that this restriction would remain for at least 10 years after publication of a White Paper in 1991, which includes a series of decisions resulting from a telecommunications policy review by the Office of Telecom- munications (Oftel) and the Department of Trade and 1ndustry.i

Three questions are paramount in assessing the merits of telephone company entry into the video market. First, how would the costs of an

0306-5961/92/020122-13 0 1992 Butterworth-Heinemann Ltd

Telephone company entry into cable relevbion

IBN compare with those of advanced versions of separate narrowband and cable television networks? The lower the cost of constructing and operating IBNs compared with separate networks (ie the greater the economies of scope in provision of narrowband and broadband services) the stronger would be the case for telephone company entry into video.

Second, what new services would be provided by telephone company construction of IBNs? A leading candidate is switched, ‘on-demand’ video. In the same way that a telephone caller can be switched to any one of multiple parties, a video user could be switched to select from a huge video library of educational, cultural and entertainment offerings. The role of switched video is of critical importance because, at the outset at least, it is the only new residential service that we foresee telephone companies providing with IBNs. It is hard to imagine any non-video information service to the home that cannot be supplied through today’s telephone and cable system.* Telephone lines can be used for personal computer links, home shopping, financial transac- tions, and access to a multitude of information services. Cable television networks carry dozens of channels, including basic service packages, pay-movie channels, and pay-per-view offerings. In contrast to switched video, cable television systems simultaneously deliver a set of video channels to each subscriber - a mode called distributive video -with the subscriber selecting a particular channel.

Third, if legal barriers to entry were removed, would two (or more) competing video networks, or only one, operate in any given local market? If sufficient economies of scale exist in provision of cable television service - a reduction in unit cost as the scale of output increases over the relevant range of output - we would expect the service to be a ‘natural’ monopoly. However, in the absence of strong economies of scale, competition among multiple video networks could result. Such potential for competition is emphasized by the United States Telephone Association in its view that ‘Telco provided video is an alternative to current viewing choices. The issue here is not one wire, but one more wire.‘3

*For a discussion of such services see Nynex, Unlocking the Information Age: Legislation is the Key, White Plains, NY, nd. 3United States Telephone Association, Position Paper: Telephone Company Pro- vision of Video Services, Washington, DC, nd. 4L.L. Johnson, and D.P. Reed, Residential Broadband Services by Telephone Com- panies? Technology, Economics, and Public Policy, R-3906-MFIRL, RAND Cor- poration, Santa Monica, CA, June 1990. ?his study proceeds under the assumption that telephone companies have access to programming under the same terms and conditions as those available to cable operators. %. Sirbu, D. Reed and F. Ferrante, ‘An engineering, economic and policy analysis of residential broadband networks’, Joor- nal of Lightwave Technology, November 1969, pp 1676-1884.

Purpose, methodology and organization of this study

This article, drawn from a previous engineering-economics study,4 traces the likely consequences during the 1990s if all barriers were abolished to telephone company entry into the video market.5 It focuses on the situation in the USA, but is also relevant to the decision in the UK not to permit PTOs to provide entertainment video on their own networks during this decade. It addresses a number of questions:

In a new community, would the telephone company construct an integrated network or would it construct a narrowband network for voice and data and a separate broadband network for video services, similar to the separate networks in place today? Would provision of on-demand video be financially attractive to telephone companies? Would telephone and cable companies compete in the transport of video services with separate networks? What are the implications for public policy?

The detailed study from which this article is drawn uses a methodology with several key elements?

TELECOMMUNICATIONS POLICY March 1992 123


7For example, in our models we assume a future cost of 10 cents per metre for fibre strands, compared to a current cost of about 20 cents; a future cost of $200 for a 2.4 Gbps optical transmitter, compared to a current cost of $2500; and $35 for a wavelength division multiplexer, compared to a current cost of about $100. Johnson and Reed, op tit, Ref 4, p 56. *We select this network architecture because (a) the active double star resembles the digital loop carrier used in today’s telephone networks for narrowband services, making evolution to this architecture simpler than for alternatives, (b) much of the ongoing effort on developing prototype IBN components is based on this architecture, and (c) the active double star is frequently cited by telephone company analysts as a likely approach for IBNs. See, for example, P. Shumate, ‘Optical fibers reach into homes’, /EEE Spectrum, February 1989, pp 43-47. qhis figure is computed on the basis of average residential.lot size from the US Statistical Abstract. 109th Edition. US De- partment of Commerce, Washington, DC, Table 1242. ‘qhis distance of 3072 m is typical in the US telephone industry. Bellcore, Notes on the BOC Intra-LATA Networks - 1986, Bellcore Technical Reference, TR-NPL- 000275, April 1986, Ch 12.

124

intensive review of the technical literature, to provide the basis for investigating alternative network architectures and estimating costs; component-by-component cost analysis of advanced networks, with assumptions that rapid technological advance will permit large cost reductions below present-day levels;7 comparisons of the costs and technical characteristics of alternative network architectures (ie networks providing specified services using different transmission technologies); use of sensitivity analysis to test the effects of alternative assumptions and quantitative estimates; presentation of preliminary analyses and findings at professional conferences in the USA to obtain comments from participants as a basis for reassessing our cost estimates and network configurations reported here.

We begin by assessing the technical and economic characteristics of a hypothetical IBN in a large new community. Because the prospects for IBNs depend heavily on the market for switched video, we undertake an evaluation of that market, and then consider the magnitude of cost savings afforded by the IBN without switched video. We examine the prospects for competition in existing residential areas already served by cable and telephone systems, and then address the issue of cross- subsidization. After summarizing our conclusions, we briefly consider the implications for public policy in the USA and the UK.

New residential construction: base-case IBN

Consider a case that is most favourable to telephone company construction and ownership of an IBN.

l All construction is in a large new residential community where no telecommunications plant exists and where installation costs are reduced by synchronizing plant construction with that of streets, sidewalks and other infrastructure.

0 The telephone company is ‘first mover’ in providing video service, thus facing no competition from an incumbent cable operator.

l The network is built instantly, with no financial charges incurred for plant under construction.

0 Market response by households is also instantaneous, with purchase of specified services immediately rising to the levels postulated in our various cases.

We consider an all-fibre active double star network as our base case.8 This approach involves connecting the central office by feeder fibre to remote distribution units (RDUs), which are connected to individual homes with fibre distribution lines, as illustrated in Figure 1. By equipping the RDU with a switching capability, individually selected channels can be provided to homes from the signals multiplexed on the feeder cable from the central office.

We assume that all construction is below ground within a service area that encompasses a square of 1024 households, 32 homes on a side, laid out in a grid of square blocks with a mean housing density of 88 homes per street mile.’ The RDU is located in the centre of the service area, a distance of 3072 m from the central 0ffice.l’ In our model 24 RDUs plus the central office itself (which serves as one RDU) cover a total of 25 600 households.

TELECOMMUNICATIONS POLICY March 1992


Figure 1. Active double star network.

“This library is assumed to have 5000 titles in inventory, equivalent to that of a current large video cassette rental outlet. Despite its size, the library (along with equipment to automatically select and show the video materials on demand) is a small portion - 6% or less - of total network costs shown in Table 1. Our estimates do not include royalties to programme providers or other programme costs. ‘?he detailed basis for these estimates is contained in Johnson and Reed, op cir, Ref 4, Appendices A and C.

Interoffice

Distributi loop

ceder loop

Pedestal (splice point

We assume that all households in the service area subscribe to telephone service and that varying percentages also subscribe to video services. Each subscriber has at least one switched video channel with which the subscriber may select either from among 64 distributed video channels, comparable to today’s basic and pay cable television services, or from an on-demand, switched video offering.

Network investment costs, including a library of video tapes or discs available for on-demand service, are shown in Table 1.i’ For example, with an IBN video penetration level of 60% (ie 60% of households subscribe to video) we estimate that the IBN investment cost would range from $1725 per home passed for low levels of on-demand viewing to $1860 for high levels.‘*

Table 1 highlights two considerations. First, overall costs are affected by the capacity required for alternative levels of demand for switched video. This result should not be surprising, but it is useful to keep in mind when confronted with frequently voiced assertations that fibre has virtually ‘unlimited’ capacity. In fact it does have limited capacity, in any meaningful economic sense, and the cost of using fibre and its electronic components depends on traffic demands. This situation suggests that peak-load pricing of on-demand channels may play an important role in promoting economic efficiency in use of the network.

Second, our estimates are only mildly sensitive to the cost of fibre. Even if fibre cost were to fall to zero, total investment would fall only by about 6% below the level given by a fibre cost of 10 cents per metre. Of greater importance is the cost of electronics discussed below.

Integrated broadband versus separate networks

A key question is whether the telephone company would find this

Table 1. Total investment costs (in dollars) of integrated broadband network per home passed, fibre at SO.10 per metre.

% on-damand video Hours ot on-demand video per week par subscriber penetration 0.75 1.5 3 6

40 1656 1636 1622 1699 60 1725 1760 1605 1660 60 1764 1631 1994 2075



Table 2. Investment co8l (in dollars) of seqarata network8 per home paseed.

integrated broadband’ 1760

Narrowband 568

Cable televisionb 368

a 60% video penetration, 1.5 hours on-demand video per week. b 60% video penetration.

13Estimates of separate narrowband and cable television networks are drawn from the detailed analysis in ibid, Appendices E and G. 14To be sure, the substitution of fibre for copper in narrowband and broadband networks also requires the decentralization of electronics beyond the central office and headend. But the degree of decentralization is much less than that required for IBNs, which involve sophisticated electronics at or near customers’ homes. ‘?n our network model, equipment at a customer’s home is powered by a connec- tion to the customer’s regular power supply. Rechargeable back-up batteries are installed at the splice points shown in Figure 1, with emergency power carried by copper line to the customer. Batteries are located at the more accessible splice points rather than at the customer’s home to reduce battery maintenance costs.

integrated network more attractive than separate ones, each supplying a portion of the services. A conventional telephone narrowband network would supply the same voice and data services, while a conventional cable television system would supply the same distributive video (but not on-demand video) services, as postulated above.

We estimate the investment cost of the narrowband network by taking the same subscriber density as above, with 100% telephone penetration. In line with current design practice, we assume a digital loop carrier narrowband network, which requires fibre in the feeder portion and copper in the distribution 10op.l~

For the separate cable television network we consider a coaxial/fibre hybrid that takes advantage of the same technological advances we assume for the integrated network.

Table 2 shows the comparisons of costs for the three networks. The most striking characteristic is that the IBN is much more costly than the sum of the separate narrowband and cable television networks. There are

0

0

0

several reasons for the greater cost of the IBN.

The equipment and additional network capacity required for on- demand video service would add substantially to cost. The IBN would involve a large investment in sophisticated electronic equipment in remote locations. With integration of facilities, the failure of this equipment would disrupt both telephone and television service. Today, telephone companies provide highly reliable service because they confine their most fragile electronics to central- ized locations, while using a rather simple copper network to reach the customer.14 For all-fibre IBN networks additional capital investment would be required to maintain telephone service at the current level of reliability. Fibre does not conduct enough electricity to operate customer premises equipment from the central office, as is done with today’s copper networks. Back-up batteries would be required at or near the customer’s home to avoid disruptions during outages of power supplied by electric utilities. This requirement would add to maintenance costs paid either by the telephone company or by the customer. The need for such emergency back-up would be particularly annoying to subscribers who want only telephone service and who would not benefit from the substitution of fibre for copper.15

These comparisons highlight two considerations. First, what confidence can be placed in our cost estimates, since technological advances are proceeding rapidly and unforeseen events will surely occur during the time period of our analysis ? In response, we emphasize that only differences among the costs of alternative networks are relevant - not the costs measured in absolute terms. Although a major technological breakthrough might reduce the costs of IBNs below our estimates (which already include generous allowances for the effects of technological advance), the same breakthroughs are also likely to reduce the costs of separate narrowband and broadband networks. Thus differences between costs of the alternatives are likely to be less affected by technological advance than are the costs of the alternatives themselves.

A leading example is today’s rapid development of video compression techniques. If these techniques allow a high degree of compression at low cost, their inclusion in our models would lower the costs both of IBNs and of separate networks. Moreover, video compression techni-

126 TELECOMMUNICATIONS POLICY March 1992


TabIa 3. Annurkad inc mmantal Investment cost (In dollars) for switchad video service, 1.5 houm average ondemand viewing per week, 80% video penetration.

I6N investment 1760 Less investment cost of narrowband network 569 Less investment cost of cable television network 369 Switched video investment per home passed 024 Switched video investment per video subscriber 1373 Switched video annualized investment per video subscriber 297

‘lhe prospects for direct broadcast satellites and the potential application of video compression are treated by L.L. Johnson and DR. Castleman, Direct Broadcast Satellites: A Competitive Alternative to Cab/e Television?, RAND Corporation, Santa Monica, CA, 1991. 17Telephone companies do face some competition in provision of services to large business users. But their monopoly over residential users seems reasonably secure during this decade. During the next century wireless ‘personal communica- tiars networks’ may provide a competitive afternative to the narrowband wire into the home. For a discussion of the cost of capital, see Johnson and Reed, op tit, Ref 4. Appendix I. Another consideration is the economic lifetimes of network components. The physical portions of the network will have longer useful lifetimes than the electronics, which will be especially sus- ceptible to the effects of technological ad- vace. We assume a lo-year life for the electronics portion and a 20-year life for the remainder (including the fibre strands). The 20-year assumption is consistent with the evidence based on telephone company experience in California reported by B.M. Mitchell, incremental Capital Costs of Telephone Access and Local Use, R- 3674~ICTF. RAND Corooration. Santa Monica, CA, August 1989, p 19. ‘@The 13% cost of capital with lo- and 20-year time periods converts respectively to annuity factors of 0.18429 and 0.14235. The 17% cost of capital with lo- and 20-year time periods converts respectively to annunity factors of 0.21466 and 0.17769. ‘9. Baldwin and D. McVoy, Cab/e Com- munication, Prentice-Hall, Englewood Cliffs, NJ, 1988. *‘?he use of fibre may reduce maintenance costs in the local loop and in service reconfigurations (‘moves and changes’) requested by customers. According to one study, local loop maintenance co& might be reduced bv 25-40%, while UP to 40% of customer bequests require piant mod- ification or other activity that would be facilitated by the use of fibre. W. Ensdotf, C. Kowal and M. Keller, ‘Economic considerations of fiber in the loop plant’, /SSL 88, IEEE, pp 291-296.

ques would benefit the use of direct broadcast satellites, which would compete with IBNs and cable television networks for transmission of video. I6

Second, the additional cost of an IBN, even though high, would be worth incurring if the market for switched, on-demand video were sufficiently strong, as noted earlier. For that reason we turn to an assessment of on-demand video.

The market for on-demand video

First, we must convert investment costs to annualized costs, and include operations and maintenance (O&M) expenses, for the alternatives under consideration. Annualized estimates must take into account the company’s (real) cost of capital and the lifetimes of the facilities. We will take a figure of 13% for the narrowband network and 17% for the broadband network (pre-tax but net of inflation) to reflect overall differences in risk. Residential telephone service involves less investor risk than does video service, because of uncertainty about competition from alternative video systems, such as video cassette rentals and direct broadcast satellites. l7

The supplier of an IBN will have an overall single cost of capital reflecting the investor’s reaction to the levels and mixture of risk. This cost will reflect a weighted average of lower-risk narrowband and higher-risk video services. Because we are concerned with the incremental cost of switched video (including its separate cost of capital) we proceed as follows. As illustrated in Table 3, we subtract the cost of providing narrowband service using a copper/fibre hybrid from the total cost of the IBN. We assume that investors regard as a low-risk investment (13%) a least-cost narrowband system, which is our copper/ fibre hybrid ($568 in Table 3). All additional investment costs of the IBN ($1192) are attributable to video services that incur a higher cost of capital (17%). After subtracting the cost of the non-switched video network, we have the incremental cost of switched video, which we convert to a cost per video subscriber. This cost is then annualized, with our estimate running to $297 per video subscriber.‘*

We estimate O&M expenses by drawing evidence from the cable industry. According to one study, a typical urban cable system has O&M expenses (less programming costs) of about $124 annually per subscriber. Network maintenance constitutes $28 of that amount.” With the installation of fibre, illustrated in our hybrid broadband cable system, network maintenance costs may fall.” Let us assume that the use of fibre reduces network maintenance by 50% below the $28 figure. In this case per subscriber O&M would fall to $110 or to about 18% of the $614 cost per subscriber for the hybrid cable system.

We will take for illustrative purposes an incremental O&M expense for on-demand video service equal to 15% of the incremental invest-



“We reduce the estimate to 15% to account for the possibility that the incremental O&M expense for on-demand service would fall below the average O&M expenses for the overall network. Thus, for example, 15% of the investment of $1373 for switched video in Table 3 is added to the annualized investment of $297 in Table 3 to obtain the figure of $503 per subscriber shown in Table 4. **Domestic and foreign video rentals and sales constitute 46% of the revenues of the US motion picture industry (Motion Picture Investor, .Paul Kagan Associates, Carmel. CA, 22 Januarv 1990. D 21. 23British Tetecom in pahicular’has’been a leading advocate of passive optical networks which avoid placing any active electronics in the distribution plant except at the customer premises. K. Oakely, Fibre to the Home - The Passive Bus Way, British Telecom, Network Technology and En-

9 ineering, London, nd. “D. Reed, Residential Fiber Optics Net-

works: An Engineering and Economic Analysis, Artech House, Boston, MA, 1991.

Table 4. Incremental annual total cost (In dollars) of on-demand video setvIce per subscriber.

% on-demand video Hours of on-demand video per week per subscrlber penetration 0.75 1.5 3 6

40 694 772 746 704 60 461 503 530 562 60 372 393 419 446

ment of on-demand service.*l On this basis the total annual investment and O&M expenses are shown in Table 4.

Whether on-demand service is financially attractive in light of the figures in Table 4 depends on revenues collected by the company and payments to programme suppliers. To illustrate, suppose that viewers watch an average of two 1.5hour programmes per week for which they pay $6 each. Suppose further that the company splits the revenues SO:50 with the programme supplier (a split typical for pay television programmes). The net of $312 per year would fall short of covering total costs even at an 80% penetration level.

The market for on-demand service would be offered on top of the diversity of basic and pay services already available on cable in the USA. Presumably these services would be offered by the telephone company as well, either through an IBN or by construction of a separate broadband network. All subscribers to a separate cable system would have addressable converters that permit them to view programmes on a ‘near’ on-demand or pay-per-view basis. For example, they could request and pay separately for live sports and entertainment programmes and could enjoy much of what otherwise could be offered by on-demand video. The principal difference is that near-demand video available today requires that the viewer watch the programme at a set time, but with the possibility of repeats, while on-demand video would permit the viewer to dial a programme on impulse and to control viewing (eg pause, fast forward) as can be done with today’s video cassette recorders. The key question is, how much would viewers be willing to pay for these additional capabilities? The possibility that these payments would not cover costs is suggested by the fact that the costs displayed in Table 4 exceed the total amount of roughly $300-350 that US subscribers today pay annually for aZZ cable television services.

The core problem is that video switching, multiplexing and equipment are expensive in the face of an uncertain market for switched services. The movement by cable operators to pay-per-view and continued growth of the video cassette market will strengthen the alternatives to on-demand video.”

A number of other IBN architectures, beyond the active double star, are also under consideration. Examples are the switched star, bus and passive optical networks.23 A comparative analysis of these approaches by Reed shows that, while they would be more attractive than our base-case IBN in some cases, they are still more costly than the overall cost of separate narrowband and broadband networks.24

An integrated network without switched video

The preceding analysis suggests that the company would build two networks (with coordinated construction) because the additional cost of building an integrated network to provide switched video would probably fall short of the additional revenues from that service.

However, another possibility arises. The savings from not offering


25Johnson and Reed, op tit, Ref 4, p 27. 261n Johnson and Reed, op tit, Ref 4, p 82, we calculated the cost of a narrowband fibre-to-the-kerb network at $879 per home passed, compared to the lower cost of $568 shown in Table 3 for a digital loop carrier. Thus the evolutionary approach treated here would involve an initial cost penalty.


switched video (and transmitting only distributive video) on the IBN could conceivably be so large that the cost of the IBN without this service would fall below the overall cost of the two separate networks. Our estimates show that the investment cost of an IBN active double star without switched video would be $1449, compared with $1760 for a switched IBN with 1.5 hours per week of on-demand video per subscriber - a saving of $311 per home passed.25 The separate networks are still cheaper, with a combined cost of $936 as shown in Table 2.

This result should not be surprising. It simply reflects the fact that the tree and branch architecture used today by cable operators is an effective mechanism for distributing video services. In contrast, efficient delivery of switched services calls for some variant of a star network. Combining the two services onto a single system can actually add to costs. In other words, economies of scope seem not to exist in bringing together broadband and narrowband residential services. Contrary to the implications of some descriptions of fibre to the home, there is nothing magic about services ‘integration’. Whether integration makes sense depends on the facts at hand.

Fibre to the kerb and network evolution

Another alternative to our base-case IBN, known as ‘fibre to the kerb’, involves a much higher degree of common plant in the distribution loop, by bringing fibre to a pedestal (or underground vault) shared by perhaps four to eight users. The optical network interface (ONI) and other electronics would be installed in the pedestal, and conventional copper drops would bring signals into the home. This architecture stands in contrast to our model narrowband fibre/copper network where the ON1 would be placed in the RDU, shared by hundreds of households, with copper (rather than fibre) installed from the RDU to the home. The fibre-to-the-kerb approach is viewed by some as an attractive way to install fibre in the network for eventual upgrading to IBN service.

To illustrate, suppose that the telephone company embarks on a strategy to bring fibre progressively closer to the home to deliver narrowband services alone, eventually extending fibre to the kerb. Later the firm retrofits the network to carry broadband services too.

Whether it would be better to maintain separate broadband and narrowband networks or to upgrade the narrowband network to provide broadband service at some future data depends upon two issues: (a) Could narrowband electronics be upgraded easily by simply adding components, or would previously installed electronics have to be replaced? (b) Would additional fibre be needed for broadband service (ie is the initial network architecture flexible enough to permit new broadband services without installing more fibre in the network)?26 Among many considerations, the cost of upgrading would be affected by the narrowband architecture in place and the kind of architecture desired for the particular broadband services to be carried. Clearly, whether fibre to the kerb would be an appropriate strategy for network evaluation depends on a complex set of factors.

One possibility is to delay the upgrade to broadband to take advantage of technological advances that would reduce costs below our estimates. However, this strategy of pushing the time frame forward raises two problems. First, intervening technological advances will benefit the narrowband hybrid and the cable hybrid networks as well.



27According to one study, if multichannel competition to cable television arises from any quarter, it is most likely to come from direct broadcast satellites: Johnson and Castleman, op tit, Ref 16. 2dFor a survey of emoirical studies on the economies of scale in cable television, see SM. Besen, Declaration (regarding cable television), US District Court. Eastern Dis- trict of Cakfornia, No CIVS8&1034MLS, 9 May 1985. The bleak prospects for over- building are discussed in Multichannel News, 13 April 1987, p 17. “In the USA 40-49 directly competitive cable systems have been reported out of more than 9000 systems in operation: Federal Communications Commission, Report, MM Docket No 89-600, 5 FCC Record 4962, 1990, para 96. 7.W. Hazlett, ‘Duopolistic competition in cable television: implications for public policy’, Yale Journal on Regulation, Vol 7, No 65, 1990, p 27. See also the objections to Hazlett’s analysis by H.K. Smiley, ‘Reg- ulation and competition in cable television’, and Hazlett’s reply, ‘A reply to “Regulation and competition in cable television”,’ same journal issue.

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Thus the differences in cost, which are key to our analysis, would be affected less than one might expect by examining the effects only on IBNs. Second, telephone companies will face progessively stronger competition. Cable operators will continue to expand the availability of pay-per-view service; the use of video cassette and disc players will probably increase along with video rentals and sales; and direct broadcast satellites may emerge as powerful competitors in delivering television programmes to the home.27

Competition with cable television operators

Once the telephone company provides video service as described in the above ‘new community’ scenario, is a cable operator likely to enter the same market, ie to ‘overbuild’ the existing video network? The answer is almost surely no. The situation is no different from that of a prospective cable entrant facing an incumbent cable operator. Given the strong economies of scale and scope for construction of facilities for television delivery, the industry has the characteristics of a natural monopoly.28

This situation is reflected in the fact that few instances of direct competition between cable systems have occurred.29 Threats by a prospective entrant are commonly empty or are followed with a buy-out. In either case, only a single firm survives in a given area.

To be sure, some analysts argue that this situation is not so much a reflection of natural monopoly as it is of the need by prospective entrants to obtain municipal franchises, which municipal officials are reluctant to grant. For example, Hazlett concludes that ‘the difficulties faced by competitive entrants arise not so much from natural monopoly conditions as from the ability of incumbent suppliers to transfer monopoly rents to municipal officials so as to protect their exclusive franchise’.30 If Hazlett is correct, the obvious solution is to abolish municipal entry barriers. A key conclusion of our analysis is that elimination of the cross-ownership ban, on top of abolishing local entry barriers, would not greatly add to competitive pressures because telephone companies have no special economic advantage over cable operators in entering the residential video market.

What about the reverse situation? Suppose that the cable company is able to install its system while the telephone company network is still in the design phase. Would the telephone company proceed to offer a competitive video service? The answer is again no. The problem for the telephone company is the absence of economies of scope in the combined transport of switched narrowband and distributive video services in an IBN. The company saves money by installing separate switched narrowband and distributive video networks because of differences in preferred network architectures for switched and non-switched services. Thus the telephone company would face the same situation as a prospective cable television entrant.

In summary, the above outcomes involve two networks: one for switched narrowband services, the other for distributive video. To be sure, economies might be afforded by a single entity installing and operating the two systems. For example, the costs of maintenance crews may be reduced if they were integrated into a single organization. Savings might also accrue in office and other administrative functions.

At the same time, a merger could preclude whatever competition would otherwise occur between the two networks. Although competition in video transmission is unlikely for the reasons previously discus-



sed, other possibilities for competition arise. For example, cable companies might offer large business users unswitched voice and data channels to bypass local telephone facilities for direct access to long- distance carriers. Moreover, using downstream video with their up- stream data capabilities, cable operators might develop information services (including still-frame video displays of data and pictures) in competition with information services provided by telephone networks. Some US cable operators are expressing strong interest in modifying their networks to serve the rapidly expanding cellular telephone market. Although such applications are of little significance today, they could grow during the decade to raise concerns about the desirability of mergers between telephone and cable companies.

Service to existing residential areas

The preceding involves only a hypothetical large new residential community where all telecommunications investments are yet to be made. What about the more common case of existing communities already served both by the telephone company with a conventional narrowband network and by a cable operator with broadband service? This situation is particularly relevant in the USA, where about 90% of the homes are passed by cable and more than 50% of households subscribe.

Here telephone companies would face severe difficulties in seeking to provide video service because of competition from incumbent cable operators. The same technological advances that enhance fibre’s attrac- tiveness to the telephone companies would also enhance its attractive- ness for cable systems. Some cable operators are already retrofitting their backbone trunk lines with fibre. This reduces the number of amplifiers in cascade, thereby improving signal quality by reducing noise and cutting maintenance costs. This trend will continue as technology advances.

The gradual introduction of fibre into the network favours the cable operator. The use of fibre in the trunk lines immediately improves video service to downstream subscribers, since they are already attached to the network by broadband coaxial cable. But fibre installation in the telephone company’s feeders does not, by itself, provide any video service to telephone subscribers because they are connected to the network only with narrowband copper lines. Thus the cable operator can progressively retrofit portions of the plant, simultaneously improving quality of service, while the telephone company would face an awkward and potentially expensive cut-over to bring video down to the last link to its subscribers.

Because it is easier to install fibre to new homes, free of existing telecommunications investments, than it is to retrofit, our model focuses on a large new community. Since new construction increases the number of new US households by 1.5-2% annually, one might conclude that perhaps 15% of US households might be served by telephone service over fibre by the year 2000. But such a calculation is misleading because of the piecemeal character of new housing construction. Consider, for example, a new house constructed on a vacant lot among existing dwellings. Even if fibre is used in the feeder, as is done today with digital loop carriers, the telephone company would find it unecono- mic to run new fibre in the distribution network only to the new dwelling while continuing use of the existing copper plant to the rest. Fibre



service separate from existing copper service will probably be attractive only for a new residential development large enough to be served by new distribution lines from existing or new central offices.

Cross-subsidization

Despite our high estimated costs for IBNs, concerns have been widely expressed (particularly by cable operators) that telephone companies could cover these costs by raising rates to their telephone customers. If so, they could uneconomically compete with cable operators and perhaps eventually dominate the video market.

Use of IBNs poses the danger of cross-subsidization because of the large element of common costs involved in delivering multiple services. With the same fibre-optic strands and electronics delivering both narrowband and broadband services, regulators would face a formidable task in determining whether revenues are sufficient to cover the cost ‘caused’ by each service. One possibility regulators might pursue is to allocate to narrowband services the costs that would have been incurred by constructing a separate narrowband network (along the lines in our models above) and to regard the residual as being attributable to video services and therefore to be borne by video customers. But any such approach would be awkward and controversial. For present purposes two points are worth making.

First, the use of price caps as a substitute for traditional rate-of-return regulation would help to reduce the danger of cross-subsidization. By putting narrowband and broadband services into separate baskets, in a regulatory system tied to prices rather than to costs, telephone companies would face greater difficulty in shifting costs to their narrowband subscribers. To be sure, the use of price caps does not entirely avoid the ‘cost push’ character of rate-of-return regulation. Regulators cannot ignore the firm’s rate of return in establishing a price-cap formula or in adjusting it over time. Thus the firm might attribute a large portion of common costs to narrowband services and, during a price-cap review, succeed in getting the cap raised for narrowband, and lowered for video, services. Nevertheless, the use of price caps, by focusing on prices, is a step in the right direction.

Many states in the USA are adopting price caps or other forms of ‘incentive’ regulation applicable to local telephone rates. In addition, the FCC has established price caps on AT&T’s interstate interexchange services and on the interstate carrier access charges imposed by local exchange carriers. 31 Earlier, in 1984, Oftel opted for price caps in overseeing the activities of British Telecom.

Second, the additional cost of constructing IBNs rather than separate narrowband and broadband networks remains large. In Table 2 the difference between the cost of the model IBN and the combined cost of the separate networks is $824 - a figure that by itself is not much lower than the combined cost of separate networks ($936). Thus our analysis suggests that massive cross-subsidies would be required to overcome the disadvantage of telephone companies in competing with cable operators. Such large amounts would not be difficult for government

31The application of price caps is cOmpUl- regulators to identify and disallow. But a problem of ‘creeping’ cross-

sory for the Bell operating companies and subsidy may arise. If the companies could spread the shift in costs over

for GTE, and voluntary for other local ex- many years, or if differences in alternative network costs are smaller change carriers. than we estimate, regulators would face a more formidable task.


Conclusions


Unless the demand for on-demand video is strong, the abolition of the cross-ownership ban is not likely to promote competition between telephone and cable television companies in transmitting video services. Telephone companies will face formidable barriers in offering integrated broadband services during the 1990s. This situation arises because of (a) the high cost of switched video services in the face of a highly uncertain market, (b) competition from cable television systems that already pass more than 90% of US households, (c) the piecemeal nature of new residential construction, and (d) the high cost of integrated facilities relative to the costs of separate narrowband and broadband networks.

Without a strong switched video market, the telephone company would be in much the same position as a cable operator seeking to decide whether to enter the market against an incumbent in existing communities. The prospects for successful competitive entry in the video market would not be bright. Thus either in existing communities or in new communities the ‘two wire’ scenario of competition for broadband services is an unlikely outcome. In existing communities either incumbent cable operators would remain sole suppliers of video or they would merge with telephone companies.

Although continuing technological advances will progressively reduce the costs of IBNs, these same advances will also reduce the costs of separate fibre/copper narrowband and broadband networks, and may also improve the prospects for competition from direct broadcast satellites. It is not clear when, if ever, technological advances will generate economies of scope in the provision of narrowband and broadband services.

For these reasons, even if all legal restrictions were lifted we conclude that households would continue to be served separately by cable television networks and by switched narrowband networks during the 1990s. In some markets both networks might be owned by one entity. In others, telephone services would continue to be supplied by telephone companies and television services by cable companies.

Policy implications

Our analysis suggests that removal of the cross-ownership ban in the USA is not likely to lead to competition by telephone companies in residential video markets during the 1990s. However, this conclusion does not necessarily mean that the cross-ownership ban should be retained. Three notable arguments support removal of the ban:

0 Additional R&D expenditures in this field may benefit society. The approaches telephone companies would take to broadband fibre R&D might vary from those of cable operators, possibly leading to unanticipated breakthroughs. Moreover, additional broadband R&D, even if it leads to no useful results, might put competitive pressure on cable operators to reduce prices and improve service.

0 Although the IBN approach does not look promising during the 199Os, continued technological advances during the next century may lead to more attractive opportunities for services integration than we have identified. Drawing a regulatory boundary between video and non-video services may encourage inefficient forms of network evolution.



0 Cost savings might accrue from integrated maintenance and administrative functions for telephone and cable television networks.

At the same time, two arguments support continuation of the ban:

0 Anti-competitive mergers may take place. Although we conclude that competition in the video market is unlikely, we have noted other possibilities of competition between telephone and cable companies. The problem faced by policy makers here is no different from that in other industries (eg the airlines). One can point to potential cost savings and other efficiencies of merged operations, and at the same time be concerned about the potentially undue concentration of market power.

0 Cross-subsidization would remain a danger. Use of price caps would help, but concerns will persist about whether the regulatory regime will prevent cost shifting at the expense of telephone subscribers.

Also notable is a problem we have assumed away in this study - access to programming under reasonable terms by competitors to cable. We have assumed equality of access to programming between cable and telephone companies to show that, even with equal access, the prospects are dim for competition in video markets. But the prospects for competition from other directions could hinge on the adequacy of programme supply. Issues of programme access are currently, and properly, of concern in the US Congress and elsewhere.

The decision in the UK to retain the prohibition on PTOs from using their own networks for providing video services will probably have little effect on the potential competitive environment faced by cable operators. For the same reasons as discussed above, the prospects for competition by telephone companies in the UK would be bleak even in the absence of legal barriers.

Under the recent decisions in the UK, PTOs may, through separate subsidiaries, apply for local franchises to provide cable television service in response to advertisement by the Independent Television Commission. 32 Our analys’s 1 suggests that in cases where PTOs win franchises they will behave essentially as other franchisees do. The fact that the parent company supplies telephone services will probably confer no notable advantage in video markets.

Finally, although PTOs are not permitted directly into the video market, cable operators are free to provide voice and data service in competition with the PTOs. We have not explicitly included this situation in our models. However, we offer three observations:

l The most feasible networks would remain non-integrated in the sense that separate lines would carry broadband and narrowband signals (with sharing of ducts, conduits and other facilities) and without the requirements for highly decentralized electronics imposed by fibre-based IBNs. As in the USA, competition in voice and data transmission will most probably arise in business markets, not in residential markets of concern in this study. Even if competition were to emerge in voice and data transmission between cable operators and the PTOs, residential video markets would probably remain closed to competition between the two - for all the reasons discussed above - even if the PTOs were granted full freedom of video entry.

0

l

32Department of Trade and Industry, op tit, Ref 1, p 29.


Telephone company entry into cable television: A re-evaluation

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