Divestiture and regulatory policies

Divestiture and regulatory policies Implications for research, development and innovation in the US telecommunications industry

Robert G. Harris

This article reviews recent changes In the structure of the US telecommunlcatlons Industry and In public policies followlna the dlvestlture of AT&T, and examines thelr lmpllcations for R&D and Innovatlon. A brief revlew of changes In the organization of R&D in the former Bell system Is followed by 8 conslderatlon of the effects of market structures on R&D incentives and organlzatlon. Finally the article examines the effects of the line-of-buslness restrlctlons imposed on the reglonal holding companies by the Modification of Final Judgment, the FCC’s requlrement for open network architecture, and rate-of-return regulatlon by state utlllty cdmmlsslons. The central concluslon of the article Is that US telecommunlcatlons pollcles may undermlne lncentlves for R&D by the Bell operatIng companies while providing conslderable Incentives for them to turn to forelgn manufacturers for new technology* Robert G. Harris is Associate Professor and Chair, Business and Public Policy Group, Walter A. Haas School of Business, University of California, Berkeley, CA, USA. The author is grateful to Richard Shin and Jaithara Suckprasert for research assistance; to Richard Gilbert, Molly Macauley. Michael Russo, David Teece and an anonymous referee for helpful comments; Continued on p 106

0306-5961/90/020105-20

@ 1990 Butterworth

In

the three and a half years since

cornpanics

by AT&T,

there

the divcstiturc

of its Bell qxxlting

have been substantial

changes in the

organization of research and dcvclopmcnt in the rcstructurcd system. Although many of these changes have been positive, there are reasons to believe that the interaction of telecommunications markets and public politics may put the Bell operating companies at a comparative disadvantage in the organization of R&D activities, in their incentives for R&D expenditures, in their ability to conduct productive R&D, and in the possibilities for their profitable commercialization of successful R&D

efforts.

These disadvantages may eventually

gical compete&e

and international

munications firms. This article examines the changes wrought regulatory

reforms

on the structure

reduce the tcchnolo-

compctitivcness

of US

by divestiture

of the US

telecomand major

tclccommunications

markets and considers their probable impact on technological innovation in the industry. Of particular significance are the vertical disintegration of equipment manufacturing from the provision of tclecommunications services by the regional Bell operating companies; the vertical disintegration

of local exchange services frog

interexchange

scrviccs;

the horizontal disintegration of local exchfinge service into scvcn indcpcndent regional holding companies (RHCs); and the linc-ofbusiness restrictions imposed on the RHCs, which prohibit them from offering intcr:LATA services, manufacturing telec0mmunications cquipmcnt or broviding enhanced information services. In assessing the impact of these changes in policy and industry structure, WC realize that it is too soon to draw final conclusions from observed developments since divestiture. By its very nature, innovation is a long-term proposition; the evidence available from the short run relates to the organization of, and expenditures on, research and

8 Co (Publishers)

Ltd

105

Divestiture

and regulumr)

policies development.

R&D

Maintaining

the

wherewithal

and

may be necessary, but it is certainly

innovation. While our undeniable

principal that

concern is with

telecommunications

incentives

not sufficient

US

to invest

telecommunications,

equipment

in

for successful

markets

it is

have been

‘globalized’, in part due to the exigencies of technologies and market demand, in part to the liberalization of domestic policies in the US, Japan, the UK, performance implications substantial

France and elsewhere. of the

for

domestic

international

changes in US

Hence, in assessing the effects on

economy,

we will

competition.

We

telecommunications

also consider will

emphasize

policies

the the

and industry

structure since divestiture, and compare the new regime with market structures and public policies in other developed nations. To anticipate some key differences

at the outset,

note that only the

US has broken apart its formally integrated telecommunications system; in virtually all other countries - regardless of their regulatory policies on any other count - there remains a single, horizontally integrated provider of local, long-distance and enhanced information services. Even Italy, whose system is not formally intcgratcd, de fizcto integration. Morcovcr, where competition

has a high degree of with the integrated

carrier has been allowed (cg the UK and Japan), no substantive restrictions have been placed on the services offcrcd by the intcgratcd carrier. In the following section WC briclly rcvicw the changes in the organization of and cxpcnditurcs on R&D within AT&T and the Bell operating cornpanics since divcstiturc.

WC weigh the cffccts of the division

of the

local operating system into the scvcn RI ICs on the role, mission and govcrnancc of their chisf R&D facility, Bell Communications Research. I laving laid a dcscriptivc foundation of R&D activities, we turn in subscqucnt sections to the cffccts of post-divcstiturc and public politics on the ability of the RHCs commcrcializc structure

innovation.

First

of tclccommunications

WC: cxplorc

the implications

services markets

salient issue thcrc is the enormously

market structure to generate and of the

for innovation.

greater need for, and difficulty

The of,

dcvcloping standards for the Bell operating companies. We also considcr the probable impacts of the growing competition among the RHCs for their willingness

to collectively

sponsor

R&D

activities.

In the next section WC turn to the structure of telecommunications equipment markets, by considering the effects of global competition among equipment manufacturers,

the development of strategic alliances

among equipment manufacturers (for joint R&D, technology sharing and cross-marketing), and the vertical relations bctwcen the buyers and suppliers of telecommunications equipment. Next we examine the implications of three major policies for technological innovation by the RHCs: the lint-of-business restrictions imposed by the Modification of Final Judgment; the FCC’s Computer Inquiry III, especially the rcquircmcnt for open network architecture; and rate-of-return Confinued from p 105 and lo the Proaram in Pacific Rim Studies. Office of the Resident. University of California, for financial support. An earlier version of this paper was presented to the Telecommunications Policy Research Conference, Airlie House, Virginia, in September 1987.

106

regulation

of the Bell operating companics by state

utility commissions. The concluding section offers some general statements about the overall cffccts of divestiture on technological innovation in telccommunications. It is important to acknowledge that the body of the article deals with the effects on the regional companies, which, in our view, are on balance ncgativc. It is quite possible, though, that there have been

TELECOMMUNICATIONS

POLICY

April 1990

Divesrirure and regulatory

offsetting

benefits,

ie positive

effects on technological

policies

innovation

by

other firms in the industry.

Structure and role of R&D By the divestiture

of AT&T’s

1984 the Modification history of integrated drastically ($145

telephone

companies

(MFJ)

on 1 January

ended a century-long

service in the USA.

AT&T

itself was

reduced in size: in revenues ($65 billion to $33 billion);

billion

billion).’ created,

local operating

of Final Judgment

to $39 billion);

and net income

($7.3

billion

assets to $1.4

At the same time, seven new telecommunications entities were namely the regional holding companies, which in turn owned

one more of the Bell operating companies. A substantial part of Bell Labs, the research arm of AT&T, was split off into a new facility, Bell Communications

Research

(Bellcore),

which

is a wholly

owned

joint

venture of the seven RHCs. In this section WC review the changes in the organization of research and development after the divestiture, and consider the effects of these changes on the mission and governance

of

Bellcore. Organization

of R& D before ciivestihrrc

There is no dispute that Bell Labs was (and is) an R&D

institution

of the

highest calibre. Through its rcscarch prowess and productivity, Bell Labs and its scientists earned a reputation as perhaps the leading research centrc in the world.

Morcovcr,

through its virtually guaranteed

funding from Bell operating company ‘contract Iiccnccs’, Bell Labs had the character of a public institution and its mission was cxtremcly broad by private R&D standards. AS iI matter of AT&T policy since the 192Os, and x 3 nlattcr of law under the terms of the 1956 antitrust consent dccrce, Bell LiIbS openly licensed its intcllcctual property, including to its (now) competitors in tclccommunications cquipmcnt and network Z services. . Not

only was AT&T

required

to openly

license (and,

by its own

choice, publish) the results of Bell Labs’ basic research, it wx prcventcd from realizing the full benefits itself. Under the terms of the 1956 antitrust consent decree, AT&T was prohibited from entering the information processing business - either manufacturing or services except for its own internal use. Consequently, given its openness, the R&D ‘spill-overs’ from Bell Labs wcrc enormous, with US and foreign firms in telecommunications, computers, semiconductors and consumer electronics among the beneficiaries. While often cited as a ‘national resource’, Bell Labs was in fact a global resource. As of 1984, AT&T had 400 agrccmcnts outstanding in the USA, plus another 200 with foreign firms.3 To cite only one prominent cxamplc, the transistor ‘A. Michael Nell, ‘Bell System R&D activities: the impact of divestiture’. Telecommunications Policy. Vol 11. No 2, June 1987, pp 161-178.

*For an excellent historicalreview of Bell Labs, see ibid. See also Office of Technology Assessment. lnlormation Technology Research and Development: Critical Trends and Issues. Pergamon Press, New York, 1985, pp 111-135. 30ffice of TechnologyAssessment, op cit. Ref 2, p 113.

TELECOMMUNICATIONS

POLICY

technology so central to Sony’s success in consumer liccnscd from Bell Labs.

electronics

was

Two major reorganizations of R&D had already occurred at AT&T prior to divcstiturc. Under the terms of the FCC’s Computer Inquiry II decision, AT&T was required to ‘structurally separate’ its regulated scrviccs (intcrexchange services) from its non-regulated activities (equipment manufacturing, rental, maintenance and servicing). This separation also applied to AT&T’s R&D activities. Hence, from 1982 to 1984 Bell Labs itself shrank from 26 000 to 18 000, with roughly 4000 personnel going to AT&T Information Services (the newly created,

April 1990

107

Divestiture

and regulatory

policies

subsidiary) and another 4000 to the newly formed Central Services Organization (now Bellcore).‘l The second change was complementary to the FCC-mandated split of Bell Labs, an internal management decision reflecting concern with Bell Labs’ product development capabilities. While Bell Labs’ prowess in basic research was widely touted, it faced growing criticism regarding its failure to fully exploit its research results at the product development and commercialization stages. To more fully integrate Bell Labs researchers and development specialists into the operations of the company, R&D was reorganized along lines of business, with authority for managing design and development shifted to the head of each respective business division.s

non-regulated

Orgnnizndon of R& D ufter divestiture

‘New directions for a ‘Paul Wallich, “National Resource”,’ EEE Sr~scfrum. November 1985, p 91. 50ffice of Technology Assessment, op cil, Ref 2. p 122. %ell Labs spin-offs’, High Technology. June 1987. pp 16-22. ‘Nell, op cit. Ref 1, pp 165-l 70. *Op cd, Ref 6. p 19. gNoll, op cil, Ref 1. p 173. ‘OOp cit. Ref 6. p 17. ’ 'Wallich. op tit, Ref 4, pp 91-93.

108

At the break-up 3500 additional people were transferred to Bellcore to provide research and engineering support for local operating companies. The people transferred included research and engineering staff whose work supported local switching and network systems as well as a ‘cross section of rcscarchcrs from Bell Labs’.” During the antitrust trial, and in reaction to the announcement of the that the divestiproposed consent decree, there were dire predictions ture would have devastating cffccts on Bell Labs in the long run. Those predictions were found4 on two prcmiscs: (I) the loss of contract licence fees from local operating companics would deprive Bell Labs of the secure revenues nccdcd to support pure rcscnrch; and (2) the vertical disintegration of local scrviccs would limit AT&T’s ability to appropriate the benefits of innovation through ownership of cospecialized assets, namely central offices and local loops. The early evidence does not seem to support those predictions: in terms of patents, publications, cmploymcnt, budget, and research climate and composition, there have been no dramatic changes, perhaps even some improvements at Bell Labs since the divestiture. Bcllcorc managers and researchers have expressed concern about effects of AT&T’s financial difficulties in new business vcnturcs, and effects of competition in traditional businesses.’ Thcrc is also evidence of II substantial increase in the rate of turnover among Labs employees since divestiture, but even then the current turnover rate is comparable to that experienced by other large R&D facilities.’ Indeed, even though AT&T was greatly reduced in size, R&D expenditures have increased by 60% since divestiture, leading Noll to speculate (on the basis of R&D expenditures of comparable firms) that AT&T may even be ‘over-investing’ in R&D.” The Labs’ research budget is now 7.5% of AT&T’s $3 billion total R&D budget, compared to 10% of Bell Labs’ $2 billion ovcrall,budgct before divestiture.“’ While observers may well disagree on whcthcr AT&T is now spcnding too little or too much on R&D, there is little disagreement that the fundamental purpose of R&D has changed dramatically. Both Bell Labs and Bellcore have assumed new charters to replace the old Bell Labs charter of providing the technology base for the telephone system. While Bell Labs and Bellcorc may both continue to consider the problems of providing, neither can mandate a unified solution.” There is an additional concern over the ‘privatization’ of knowledge and research results. AT&T is rcquircd, under the MFJ, to issue licences to the RHCs on all existing patents, plus non-patentable

TELECOMMUNICATIONS

POLICY

April 1990

Divestiture and reguhory

policies

information funded by licence contracts. On new patents, however, the MFJ licensing requirement covers only five years after the date of divestiture. Moreover, while AT&T continues to license many of its patents to non-RHCs, it is no longer required to do so (MFJ lifted that requirement of the 1956 Consent Decree). AT&T has publicly announced that it now regards patents as assets, evaluates each licence request on its merits and grants licences only when it finds a business advantage in doing so. But AT&T’s strategic approach to R&D should hardly be surprising. For at least three reasons we would expect a high level of R&D expenditures after the break-up. First, AT&T had a window of opportunity during which it could get a ‘leg up’ on competitors. Given the line-of-business restrictions on RHCs and AT&T’s well-established position in the switch market (enormous embedded base, large share of new shipments), an intensive R&D effort is crucial to sustaining its competitive advantage as foreign manufacturers enter the market and after (assuming that) the RHCs are allowed into enhanced information, manufacturing and/or long-distance services. Second, so long as revenues from regulated services constitute a large share of its total revenues, AT&T can include a substantial share of its R&D expenditures in ‘allowed expenses’ for long-distance rate-making purposes. Under the FCC’s ‘composite allocator’ rule, 50% of AT&T’s R&D costs are paid by regulated AT&T Communications, 50% by non-regulated AT&T Technologies and AT&T Information Serviccs.‘2 AT&T revenues in 1985 included $17 billion in rcgulatcd services (toll, installation, maintenance); $11 billion in cquipmcnt salts; $6 billion in rentals.” Hence, 50% of R&D goes into allowed operating cxpcnscs for long-distance rates. We arc not suggcsfing, nor do we bclicvc, that the cost allocation of R&D expenses to AT&T Communications is inappropriate; the users of intercxchangc scrviccs may well be rccciving at least a proportional share of the benefits. The point is that under rate-of-return regulation the incentive to spend on R&D is cspccially strong when revenues are producing profits in excess of the allowed rate of return, as has in fact been the case for AT&T. Third, AT&T is losing share in long distance, and rental revenues will continue downwards. Looking into the future, AT&T needs new sources of revenues to maintain its long-term growth trajectory. Espccially with long-distance customers paying a share of the costs, AT&T has an opportunity to harness the labs in an effort to develop the new products and services of the future. Sooner or later, though, competitive pressures may force AT&T to devote a larger share of R&D to product development, less to long-term research. technical

Organization of R& D among the regional Bell holding companies

120ffice of Technology Assessmenf op cif. Ref 2. p 129. “Steven Globerman and James Diodati, ‘Market structure, internal organization. and R&D performance in Ihe telecom-

munications industry’, Ouarterly Review ol Economics and Business. Vol20. Winter 1980. pp 70-85.

TELECOMMUNICATIONS

No 4.

Since divestiture, virtually all organized research and dcvclopment activities of the RHCs takes place at Bell Communication Research, which is wholly owned by the seven regibnal holding companies. As of 1986 Bellcore had 8000 employees, 4600 of whom worked in Technical Services: 500 in applied research and 4100 in network planning, software development, quality assurance and new service planning. Bellcore projects arc of two basic kinds: core projects are conducted on behalf of, and funded by, all seven RHCs; client projects are conducted for, and funded by, one or more RHCs, each of whom must individually agree to participate as sponsor. Of Bellcore’s total budget, one-third is

POLICY April 1990

109

Diveshue

and regulatory policies

spent on core projects. two-thirds on client projects.” Whereas core projects provide results to all seven RHCs, client project results are shared only with project sponsors. As a research cooperative, Bellcore has experienced the problems inherent in collective decisionmaking over which projects to fund and for how much. US West in particular has expressed concern about Bellcore governance and the need for consensus among the owners in the funding decision process.” In January 1957 US West notified Bellcore of its intent to sell its share of stock, effective 1 January 1990. Although perhaps only a formal compliance letter (providing the necessary three-year notification), US West was reportedly protesting Bellcore’s governance by consensus process while stating its need for Bellcore to conduct more proprietary research.” While it has a substantial budget (approximately $800 million) Bellcore’s scope limits activities since only about 500 employees are working in applied research. In an effort to contend with this limitation, Bellcore is a participant in the Microelectronics and Computer Technology Corporation and is engaged in collaborative research with the US Army Electronics-Technology and Dcviccs Laboratory, ADC Telccommunications and Hitachi. US West’s notification lcttcr notwithst~inding, most reports of RHC relations with Bcllcorc arc quite positive. The three RHCs intcrvicwcd by Nell wcrc very enthusiastic about Bcllcorc, cvcn though thcrc arc conflicts bccausc RHC non-rcgulntcd busincsscs (cg cellular tclcphonc scrvicc, ovcrscas cnginccring scrviccs) arc somctimcs compctitivc. Pacific Bell treats Bcllcorc as il According to one of its cxccutivcs, an cxtcnsion of their own staff.” ‘vendor with a client relationship’, Even so, rcccnt actions by Pacific Bell antI others feed rumours thilt the I<1 ICs will bc increasingly ‘going it alone’. In their design and testing of Project Victoria (a prototypic intcgratcd scrviccs technology), Pacific Bell conducted the rcquisitc rcscarch in house. Likcwisc, Pacific Bell has opted to dcvclop and USCits own system, rather than fund I3cllcorc’s Trunk Integrated Records Keeping System (TIRKS), which cost each of the other six RHCs $10 million in 1985.” One argument for dcvcloping grcatcr in-house R&D capacity is that the RHCs need their own rcscarch capability, if only to measure, monitor and decide whether to fund Bellcore activities. A second argument is that, as the RHCs compctc in more markets and attempt to differentiate their services from each other, their need for proprietary research and rcscarch know-how will incrcasc. WC examine that possibility in the following section. Mission of Bellcore R&D

“Bell Communications Research, Annual Report. 1966. 15Johnnie L. Roberts. ‘US West mav end its role in Bellcore. ;he 7 Bell firms’ big research venture’. Wall Sfreet Journal, 14 January 1987. p 5. “Telephony, 19 January 1967, p 13. “‘Bellcore struggles lo prove itself, deData Communications, spite critics’. November 1966, pp 78-79. “Ibid.

110

In response to the MFJ’s vertical disintegration of Wcstcrn Electric from the operating companics and in light of MFJ’s ban on RHC manufacturing, Bcllcorc’s central mission was rather obvious: to providc technical support for the RI-IQ cquipmcnt-buying decisions. A to dcvclop standards for key aspect of that mission is, of course, to cnsurc compatibility within and across local multiple vendors, operating systems. WC cxaminc that subject in grcatcr depth below; suffice it here to note that, in providing procurement-related technical support to the RHCs, Bcllcorc needs to keep ahead of - not merely up with - equipment manufacturers, anticipating mcnts by doing its own research. This research

TELECOMMUNlCATlONS

state-of-the-art

capacity

dcvelop-

and knowledge

POLICY

April 1990

Divesriture and reguhory

base is essential

to Bellcore’s

ability

to specify,

evaluate

policies

and test

products for the RHCs.lY Given

the increasing competition

services (eg private networks, important

stake

in promoting

central office switches other

Bellcore

in the provision

innovation

and local network

missions,

accordingly,

equipment developments

of local network

carrier bypass), the RHCs by the

also have an

manufacturers

systems and software.

of Two

are to keep abreast of emerging

and disseminate any discoveries that Bellcore

makes to manufacturers of communications equipment.“’ This explains Bellcore’s patents and licensing policies. While Bellcore does seek patent protection for intellectual properties, they encourage vendors to share the fruits of Bellcore’s inventions, and this has led to a fairly open publication and licensing policy. This interest in disseminating knowledge derived from research, design and testing activities is also reflected in the publishing records of Bellcore employees. Of course the main reason why Bellcorc openly publishes and licenses is the line-of-business

restrictions

on the RHCs,

which also apply to

Bellcore. Since Bellcorc and the RHCs arc prohibited from developing or manufacturing telecommunications equipment themselves, Bcllcorc can only

specify the criteria or design standards outside vendors’ Bcllcorc can only mnkc rccomcquipmcnt should meet. Furthcrmorc, mcndntions on design specifications or standards to the Rf ICs, who arc free to accept or rcjcct them. Any effort to impost mandatory standards would surely bc challcngcd on antitrust grounds.” In that context, Bcllcorc fnccs a difficult technical problem in defining the boundaries Under

of the lint-of-business

the MFJ,

restriction

on manufacturing.

is allowed, while cquipmcnt dcvclopmcnt and manufacturing arc not. It is increasingly difficult to make that distinction, howcvcr, as technological change complicates the diffcrcntiation

software

of R&D

dcvclopmcnt

into cquipmcnt-

or software-rclatcd,

hardware is rapidly becoming more software

Although

Bellcore’s

bCCilUSC

intcnsivc.”

budget is a very substantial

$800 million

per year,

when measured as a percentage of the revenues (I .3X) of its owners these cxpcnditurcs arc markedly lower than other tclccommunications companies or other high-technology industries. As shown in Table I, total RHC R&D expenditures arc only 20% of AT&T’s expcnditurcs when measured as a pcrccntagc of sales. By comparison

to software

scrviccs firms, the RHCs spend only one-sixth as much on R&D (I .3X of sales vrrslcs 7.7%). Since the RHCS are allowed to research and develop their own software, this is a particularly revealing comparison. According to Table 1, the RHCs spend far ICSS on rcscarch and development than British Tclecom (BT) and Nippon T&corn (NIT), both of which are primarily telecommunications services firms with limited involvement in (but no absolute restrictions on) telccommunica-

lgOffice of Technology Assessment, op cil, Ref 2. p 129. %Vallich. op cd. Ref 4, p 93. “Ibid. p 92. “David J. Markey and Robert T. Blau, ‘Is the AT&T Consent Decree strangling American R&D?‘, Telemafics, Vol 3, No 8. August 1986, p 5.

TELECOMMUNICATIONS

POLICY

tions cquipmcnt manufacturing. Whcrcas the Bell companies collcctivcly spend 1.3% of salts, BT spends 1.7% of sales and NIT spends 3%. WC think thcsc comparisons reflect the peculiar circumstances of the RHCs since divestiture. Unlike the Bell operating companics, and notwithstanding privatization and dcrcgulation, ncithcr BT nor NIT was dismcmbcrcd horizontally or vertically. Each provides nationally extensive local exchange and interexchange tclccommunications services; neither faces significant restrictions on the provision of enhanced

April 1990

Divrsrirure and rrgulurory policies Table 1. 1986 R&D expenditures Company/industry

Sources: Corporate annual reports; Japan Company Handbwk; ‘R&D scoreboard’. Business Week. 22 June 1967. pp 139-l 56.

in communications

1986 sales revenues

and information equipment and services. 1986 as 96 of sales

1986 R&D expenses S millions

$ millions

Telecom services: RHCs/Bellcore British Telecom Comsat KKD N-f-r

62 502 12581 466 1200 28 286

603 216 26 67 757

1.3 1.7 5.6 5.6 2.7

Servicesiequipment: AT&T GTE IBM/Rolm!MCI

34 087 15 112 51 250

2 278 291 3 975

6.7 1.9 7.0

Telecom equipment: Cit-Alcatel Ericsson Fujitsu Hitachi NEC Northern Telecom Plessey Siemens ThomsowCSF

10 700 2 779 7 942 27 836 12 970 4384 2 192 34 600 22 300

1 000 231 626 1 644 917 475 122 3 300 3 600

9.3 a.3 10.4 5.9 7.1 10.8 5.6 9.5 16.1

Related industries: Computers Electronics Office equipment Peripherals Software Telecom equrpment

94 138 59311 5 147 23 021 6 069 54 502

7 057 2 566 249 1615 468 2 762

6.3 4.4 4.0 7.0 7.7 5.1

1 451 000

51 000

35

All induslry: Composite, US

information

services.

manufacturing, joint

While

neither

have

‘quasi-integrated’

both ventures

R&D

-

with

has historically

domestic

been integrated

relationships

-

tclccommunic~ttions

into

including equipment

manufacturers.

Effects of local exchange market structure The

most obvious effect

was the creation ing

loci11 and

population.

intro-LATA

In this

disintegration

of the divestiture

of seven independent toll

section

of the Bell

service

we discuss operating

of the Bell

holding

operating

companies,

to roughly

one-ninth

the implications system

system

each providof the

US

of the horizontal

on R&D

and innovation

by

the RHCs.

Sttrnrlor~li~r~iiot~urui con~patihiliry it2txchrrr~geservices The

horizontal

incrcrrscs It must USA

disintegration

the need for be remembered

has

enjoyed

in

integrated

network.

The

reduction

in

catcgorizcd

of

stilndi~rds, that

the

lociI

question

is whether

112

the

of

grc:ltly

incompatibility. compatibility

inheritance

disintegration

will

the of

the

cause

~1

compntibility

a number

0

an internal

0

mutual

0

is

network

for

level

the extraordinary

telecommunications

in the future. Farrell and Saloner have of mechanisms for standardization, which they

define as ‘a process by which compatibility

l

telephone

and the potential

is attained’:

decision by one vendor (cg AT&T

prior

to divcstiturc);

agreement

among vendors or purchasers, formal mal, binding or voluntary (cg Bcllcorc since divestiture); use of government procurement (eg PTTs in Europe); follow-the-leader (eg Unix or ‘IBM-compi;tihlc’);

TELECOMMUNICATIONS

POLICY

or infor-

April

1990

Divestiture government

direct

0

requirement, international

perhaps); and standards setting (the International

tion Union’s

ISDN

sufficiently

fourth

dominates

Telecommunica-

standards).“3

The significance of the divestiture The

policies

(the FCC’s open network architecture

regulation

0

the USA.

and regulatory

is that the first is no longer possible in

is unlikely

to occur,

any substantial

since no single

sphere

vendor

of telecommunications

equipment. The fifth is highly improbable, at least across all telecommunications products and services. The sixth mechanism, international standard setting,

is fraught

nationalistic

PITS

international

standards

with the political

(which,

it

for

should

their

contestations

be emphasized,

domestic

networks,

of fiercely

do not

need

since they can

depend on the third mechanism). That basically leaves the second mechanism, voluntary standardsetting by Bellcore (or equipment vendors), and accounts for Bellcore’s ‘technology

clearing-house’

role.

Given

the ever-present

shadow

of

antitrust enforcement and monitoring of the MFJ provisions, Bcllcore must establish reasonable standards to ensure the highest possible level of compatibility

while not skewing those standards so that they favour

any particular equipment supplicr. As part of its efforts works within of anticompctitive conduct, Bcllcorc National establish

to avoid claims the American

Standards Institute as part of an industry-wide effort to and maintain tclccommunications network connection

standards.” In spite of its antitrust

concerns and strict

adhcrcncc to voluntary

standards and design specifications, 13cllcorc has been actively sought to dcvclop standards for gcncric operating systems, network clcmcnts and the intcrfaccs among them. In pursuit of thcsc objectives, I3cllcorc has issued ‘Technical Advisor& and ‘l‘cchnical Rcfcrcnccs’, conducted ‘Technology Rcquircments Industry Forums’, Exchange Carriers Standards Association’s T-l Clearly Bcllcorc and the RHCs

and participated Committee.”

rccognizc the importance of compati-

bility across and among the local operating companics, independents. The benefits of compatibility include: (as the size of a compatible

TELECOMMUNICATIONS

POLICY

the

increases,

the

externalities

0

value of service to each user increases); competitive effects (when competitors’

0

there is typically greater price competition among them); cost savings (from scale economies in the USC of standardized and/or

0

intcrchangcable parts); and greater variety in systems design (the ability

Considerable

benefits

network

including

0

various components 23Joseph Farrell and Garth Saloner. ‘Compelition, compatibility and standards: the economics of horses, penguins and lemmings’, in H. Landis Gabel, ed. Producf Sfandardizafion as a Tool of Compefifive Sfrafegy, North-Holland, Amsterdam, 1987, p 3. 24John S. McClenahen, ‘Serving seven masters’. lndusfry Week, 25 June 1984, fp 31-32. 5A.M. Rutkowski. ‘Emerging network switching technology and applications’, Telecommunications, March 1987. p 44. 26Farrell and Saloner. op cif, Ref 23, pp 68.

in the

products

are compatible

to mix and match

and subsystems).‘” notwithstanding,

the problems

in maintaining

compatibility are not insignificant. In the abscncc of Bcllcorc thcsc problems of coordination and communication among the scvcn RIICs would bc considcrablc. There is the additional problem of the Rt ICs' large installed base of Western Electric cquipmcnt, which complicates the movement towards a new, generic standard. Of particular concern in the arca of standardization is the role of Bcllcore acting on behalf of the RHCs in international standards setting activities, which is coordinated by Bellcore’s Network Standards and Architccturc Client Program. As already noted, the PITS are structurally dissimilar from the RHCs: they each have an extensive, integrated

April 1990

113

Divestiture and regulatory policies

national network offering local, long-distance and enhanced information services and they are quasi-integrated telecommunications with one or more favoured national suppliers. Surely their interests are markedly different from the RHCs; they have an abiding interest in pushing standards in the direction of network integration, while the RHCs are, of legal and regulatory necessity, being pushed in the direction of open network configurations. Furthermore, one should not underestimate the role of the P?Ts and their respective governments in the international standard-setting process. Given their leverage in respective domestic political arenas, the PITS can be expected to become ‘entangled thoroughly in dynamic market rivalries between sponsored-system standards’.” In comparing Bellcore’s R&D expenditures to other telecommunications firms, it should be noted that a substantial share of these expenditures is devoted to ensuring continuing compatibility through standardization. While potential social harm is prevented thereby, this hardly represents an improvement on pre-divestiture conditions. We are certainly not suggesting that Bellcore’s specification, standardization and testing activities do not gcncratc innovative results; they may well do so. We are saying that divestiture has imposed an enormous cost that was unncccssary in an intcgratcd AT&T. With vertical integration bctwccn Wcstcrn Electric and the Bell operating companies, Bell Labs could conccntratc on designing and dcvcloping hardware and software, rather than on specifying standards for outside vendors. As WC will see, the cost of standardizatiori imposed by divcstiturc is likely to grow as time passes.

Given divcstiturc, and quite al~ilrt from the need for standardization among the RI ~CS, there arc considerable bcncfits of coopcrativc research, both private and social. The social benefits of cooperative research include: 0

0

0

2’Paul A. David, Some New Standards for the Economics of Standardization in the Information Age, Working Paper No 11. Center for Economic Policy Research, Stanford University, CA, August 1986. pp 47-49. “Gene M. Grossman and Carl Shapiro, ‘Research joint ventures: an antitrust analysis’, Journal of Law, Economics. and Organization, Vol 2, No 2, 1986. pp 351356. -Ibid, pp 324-325. 30Michael Katz, ‘An analysis of cooperalive research and development’, Rand Journal of Economics, Vol 17, No 4. Winter 1986, p 529.

114

e.r utlte incentives to invest in R&D: cooperation among competitors may SOIVCappropriability problems (ic leakage of the results of R&D, lowering the returns to R&D expenditures); economics of joint research, including economics of scale, synergism or complemcntarities among participants, avoiding duplication, and risk sharing; cooperatives treat knowledge as a public EX posf dissemination: good, at least among members, which guarantees diffusion of the results of R&D and thcrcby increases the return on R&D; in fact, a ‘cooperative research effort may be viewed as an ex utlfe licensing agreement with zero licensing fees’.”

Thcrc arc potential social costs of coopcrativc rcscarch as well. These include the loss of dynamic cfficicncy in R&D (when firms USC coopcrativc research vcnturcs to slow the pact of technological innovation, thereby protecting physical assets, human capital and/or market positions); and anticompctitivc dangers in product markets, such that ancillary restraints arc attached to coopcrativc R&D ventures.2” As a rule, the net incentives for, and social bcncfits of, cooperation are positive when participating firms sell their outputs in unrelated product markets, as do the RIHCs.“” Nelson has argued that the advantages of sharing R&D results among

TELECOMMUNICATIONS

POLICY

April 1990

Divestitureand regulatorypolicies rivals lie in areas of research where the results are difficult to keep proprietary, especially in instances when the industry can collectively benefit by developing uniform standards for the products of upstream industries. Although many industries have traditionally funded this type of work collectively, through some kind of voluntary tax formula. there are obvious free-rider limits on such mechanisms, as well as technology transfer problems.3’ In considering the incentives for and benefits of cooperative research by the RHCs, we note that Bellcore prevents free riding among its owner-members for core projects, but independents, who may well buy the same equipment, do free ride. Also note that in the typical case of cooperative research, members use the results directly, in the production and sale of goods or services. In the RHCs’ case, given the line-of-business restrictions, Bellcore must either license or give away its results to supplying firms. We will expand on this point in the next section. Competition

among

cooperrrtors

University Working Paper, New Haven, CT, August 1986, p 30. %oberts. op cif. Fief 15, p 5. =/bid. p 6.

Private incentives for cooperative R&D are most likely to be positive when firms sell their products in unrelated markets. In other words, firms are more likely to cooperate when they do not compete. At the time of divestiture, of course, the RHCs fit that bill complctcly. They had very strong mutual interests in quickly dcvcloping a collcctivc rcscarch, dcvclopmcnt, standardization and testing capability, the cost of which could then be spread over the seven owners. In the ycnrs since divcstiturc, howcvcr, the RIICs have increasingly bccomc (especially in non-rcgulatcd lines of business such as tclcphonc cquipmcnt marketing and cellular tclcphonc scrvicc), and pcrccivc thcmsclvcs X, competitors. There arc already signs of the tensions of emerging competition in the govcrnancc of Bcllcorc, in the RIICs’ relations with Bellcorc, and in the cstablishmcnt of internal R&D groups at the RHCS. Although wholly owned by the seven RIlCs, and cvcn with fairly close and cordial relations bctwecn Bcllcore and its owner-mcmbcrs, the fact remains that Bellcore is an ‘outsider’ in one critical respect. Hcncc it seems probable that as the RHCs continue to branch out in new directions, and compete directly in some markets, they will increasingly want to privatizc their technological dcvclopments. As they do so, Bellcore may be cut out of top-priority projects, since individual RHCs arc not likely to leave the development of key, competitive technology to outsiders. We expect two main effects of growing competition among the RHCs on the organization and conduct of R&D. First, Bcllcorc will shift its efforts from core projects shared by all scvcn RI-!Cs to proprietary, client-oriented research and development. US West has already argued that Bellcore research should rcflcct growing rivalry among RHCs, by undertaking more proprietary rcscarch.3’ Bcllcore has recognized the handwriting on the wall, declaring that more regional-specific work ‘will bc committed, executed and delivcrcd to satisfy separate regional Bc~~s’.“~ Over time Bcllcore will increasingly bccomc a contract rcscarch lab, which will have to compete with the RHCs’ internal labs, private concerns and univcrsitics for R&D projects. The second effect of growing RHC competition is the establishment of internal R&D groups by the RHCs. Southwest Bell and US West

TELECOMMUNlCATlONS

April 1990

“Richard R. Nelson, InsM~tions Supporting

Technical

Change

in Indusfry,

Yale

POLICY

115

Divesbrure

and regululory

policies

have announced the creation of their own R&D groups to generate needed proprietary research to support new, competitive business ventures (cautioning that they do not intend the internal groups to replace Bellcore). u Nynex has announced plans for an R&D organization of 350 by 1990, including a small applied research group of 3.5, mostly software related. Pacific Bell has a small technology tracking group, but has no plans for its own R&D facility. US West has also announced plans for an R&D facility, causing something of a ruckus over its site selection process. In addition, US West recently announced $1.2 million in university grants ‘for R&D on 10 key technologies deemed crucial in its competitive marketplace’.-‘5 The sum of these two effects, an increasing share of RHC research done internally and an increasing share of proprietary research at Bellcore, may well reduce the public benefits of research and development expenditures by the RHCs. In other words, growing competition among the RHCs will shift the balance from the social benefits of widespread diffusion to incentives for privatization. Competitiorl

34Karyl Scott, ‘Bellcore vs RBHC R&D’, Nehvork World. 25 May 1967. %fS West sets R&D pace’, Telecom Tacfits and Strategies, July 1987. p 1, 36Rutkowski. op cif. Ref 25, p 46. “Joe Kellagher, ‘US central office switch market’, Telecommunications, February 1987, p 76. =Markey and Blau. op cit. Ref 22, p 4.

116

between

exchange

arui irrterexchnge

carriers

Under the MFJ the RHCs are not allowed to provide inter-LATA services, while interexchangc carriers (IECs) including AT&T arc allowed to provide intra-LATA service, depending on state regulatory approval. In most states lECs are authorized to offer private line services; some states have authorized open entry into the LATAs. The emcrgcnce of competition bctwecn IECs and the RHCs has two main implications for innovation. First, thcrc is a technological consequence. Central office and longdistance network architccturcs arc becoming quite blurred at the boundaries.‘” Given the structural differences between the US and other national tclcphonc systems, though, it stems unlikely that world telecommunications markets will follow the same trajectory. With other carriers - the P7Ts - having integrated networks, innovations dcvelopcd for the US market will have limited applicability elsewhere. The return on US R&D will be correspondingly lower. A second consequence of the vertical disintegration of local from interexchange services derives from AT&T’s unique position as a supplier of, and competitor to, the RHCs. AT&T sells PBXs to corporate customers and Centrex switches and software to the RHCs; it sells interoffice transmission equipment to RHCs and private line services to their potential customers. Moreover, the greatest potential arena of compctitivc rivalry lies just ahcad, as AT&T develops the modifications and software needed to provide local switching and enhanced information services from its Class 4 switches, in direct competition with the RHCs’ Class 5 central office switches. Already there arc claims that AT&T is holding back software dcvelopmcnt on its 5ESS switches (which, due to pre-divestiture standard practice procurcmcnt policy, constitute a large share of the RHCs’ installed base of stored program control switchcs).J7 AT&T, mcanwhilc, is rcportcd to be rapidly developing the Class 4 switch for a central role in ISDN.“X

Structure of equipment and services In this section we briefly describe the structure of telecommunications equipment markets and evaluate the effects of the vertical disintegration

TELECOMMUNlCATlONS

POLICY April 1990

Divestiture and regulatory policies

of the Bell system on R&D and innovation by the RHCs. The discussion will emphasize the development and manufacture of central office switches (COs), related switching systems and network architecture. While other categories of telecommunications equipment (eg optical fibre and transmission equipment, PBXs) are also undergoing rapid technological development, it is evident that the design and development of switches will play a crucial role in the technological trajectory of the industry.39 We begin with a brief review of the market structure of central office switches, taking special interest in the installed base and market shares of North American verms European and Japanese manufacturers in the US market. We then investigate R&D in the equipment industry, with special attention to the recent dramatic increases in collaborative R&D efforts and the emergence of ‘global strategic partnerships’ among equipment manufacturers and PITS. We explain the notable absence of the RHCs from these strategic partnerships and its implications for RHC participation in technological innovation. Finally, we analyse the vertical relations between the RHCs and telecommunications equipment manufacturers as an example of and derive its implications ‘upstream-downstream R&D cooperation’, for RHCs’ incentives for R&D and the appropriability of innovations produced thereby. Str~ictiire

‘gRulkowski. op cit. Ref 25. p 50. 40Kellagher, op cif, Ref 37, p 76. “Ibid, pp 76. 84. 42Northern Telecom’s DMS-100 Class 5 local COs are manufactured in the USA; Northern Telecom. Inc, is a subsidiary of Northern Telecom. Ltd. a Canadian cor-

poration.

TELECOMMUNlCATlONS

POLICY

of telec0n~rrllcnicrrtion.s

cqicipr~ierit

rriorkcts

While vertically integrated with Wcstcrn Electric, the RffCs purchased more than 90% of their equipment internally. Wcstcrn Electric supplied aII of the RI10 CO needs until 19S0, when the Bell System approved Northern Telccom as a CO supplier. As of 19S6 the RI ICs hilt1 an installed base of 935 1 swithccs, the majority of which wcrc made by AT&T, with Northern Tclecom a distant second. Approximately 50% of their COs wcrc analoguc clcctronic, 32% analoguc with stored program control. and 18% digital (nearly double the number of 1985)? Overall, the US CO market (including RI ICs, GTE, indcpcndents, rural electric administration coopcrativcs and private network purchasers) is dominated by three vendors: AT&T, 45% of 1985 digital lines shipped; Northern Telecom, 38%; GTE 13%; and all others 4%. CO shipments increased 10% to 16.2 million lines in 1986 (11.7 million in 1985). By share of lines, 90% of 1986 shipments wcrc digital CO, the remaining 10% were components for expansion or modification of existing analogue systems (eg to meet Cqllill access requircmcnts).J1 The domination of the CO market by US manufacturer? may bc nearing an end, however. Several foreign manufacturers have already entered. or have announced plans to enter, the US market. One of the allegations of the antitrust suit against AT&T is that its standard practice procurement policy ‘foreclosed’ other equipment vendors from the RHC market. If true, that would imply that one of the gains of divestiture is the additional incentive for competing telecommunications equipment manufacturers to invest in R&D in an effort to gain share in the RHC market. One possible concern -seldom cxprcsscd of late-was that the RHCs would continue to purchase disproportionately from AT&T. Indeed, AT&T continues to make substantial sales to its former operating companies, although the trade press reports few claims of

April 1990

117

Divestiture

and regulumry

policies

‘bias’ in procurement

does have substantial advantages in

policy. AT&T

having such a large share of the RHCs’

installed

base:

0

RHCs’ installation, operating hnd maintenance personnel have a great deal of accumulated know-how about AT&T equipment.

0

New

AT&T

installed

l

equipment

has a high degree

of compatibility

with

for expansion

of or

equipment.

The RHCs are most likely to turn to AT&T modifications to existing equipment.

In spite of these advantages, and AT&T’s

leading market

share, there

are countervailing forces at work. Again, the root of the problem is AT&T’s unique position: it is the only company in the world with a substantial presence in both equipment manufacturing and telecommunications services that does not produce equipment primarily for its own use. The RHCs, accordingly, have considerable incentives to develop relations with other suppliers. Given that there are now only two US-based companies producing large-scale

digital

competitors,

switches

(AT&T

it is not surprising

and that

GTE),

RHCs

both

are

of which

turning

are

to foreign

suppliers. Foreign manufacturers of digital COs include: Northern Tclccom of Canada; Alcatel-Thomson and CGE-l?T of France and Uclgium;

Ericsson of Swcdcn;

Stromberg

of the UK;

and NEC.

Fujitsu

Italcom/Tclcttra

of Italy;

Sicmcns of FR Gcrnlany;

and Ilitachi

of Japan.

Plcsscy/GEC/

Tclcnokia

Northern

of Finland;

Tclccom

and NEC

have CO manufacturing plants in the USA; Sicmcns has a large R&D facility in I3oca Raton (500 specialists working on central ol’ficc switching systems). Most of thcsc manufacturers have targctcd the US market and have begun taking market

As was shown

in Table

I,

share from AT&T

foreign

cquipmcnt

in rcccnt years.

manufacturers

spend

substantial sums on R&D. In comparison to II3M’s R&D expcnditurcs of 8% of salts rcvcnucs, the Icading digital switchmakcrs spend from 6% to 16% of salts. Thcsc substantial

cxpcnditurcs

on R&D

rcflcct the

rapid growth in the demand for tclccommunications scrviccs. A rapidly expanding industry gcneratcs incrcascd demand from industries that produce

intermediate

components

and materials

for it. lligh

rates of

growth in demand in turn stimulate rapid rates of technical change in supplier industrics.“3 Even SO, the costs of developing a new switch or upgrading an existing product arc enormous.

Estimates

range as high as $1 billion to bring a

new switch to market, with an additional commitment As a conscqucncc year in product dcvclopmcnt.jJ

?3lephen J. Kline and Nathan Rosenberg, ‘An overview of innovation’, in Ralph Landau and Nathan Rosenbera. eds. The Posifive Sum Sfrategy. Na&nal Academy Press, Washington. DC, 1986. p 281. 44David J. Teece. Gary Pisano and Michael Russo, Jo& Venlures and Collaborative Arrangements in ihe Telecommunicalions Equipment Induslry. Working Paper IB-9. Center for Research in Management, University of California, Ber-

keley, CA, July 1987.

118

of $2(X) million per switchmakers arc

expanding their geographical covcragc (by adapting switches to new markets) to spread higher devclopmcnt costs and to realize growing economics of scale in R&D. The North American market is particularly attractive bccausc it rcprescnts a substantial share of the world’s total demand for COs. In addition to geographic expansion (or as part of their geographic expansion strategy) cquipmcnt manufiicturcrs arc increasingly turning to joint R&D vcnturcs and strategic alliances, which cannot be explaincd solely by scitlc economics. Tcccc, Pisano and Russo argue that it is the nature of the R&D process itself that is driving firms towards collaboration. The convergence of telecommunications, computer and

TELECOMMUNICATIONS

POLICY

April 1990

Divesriture

microelectronic

technologies

heightens

and regulatory

the interdependence

paths, which makes it ‘increasingly difficult

and inefficient

policies

in design

for the major

equipment firm to track all the relevant techological fronts for themselves. As a consequence, they collaborate to gain access to com-

plementary technologies.‘45 In their equipment

study of 117 joint manufacturers,

ventures

Teece,

involving

Pisano

telecommunications

and Russo

found

50 part-

nerships in distribution or cross-marketing; 15 of those also involved R&D or technology sharing. There were three main reasons: companies agreeing to integrate their product lines into a system (eg the AT&T

and

EDS agreement to develop and market specially designed computer and communications systems); a product must be modified for use in particular market, with local know-how required or advantageous; or production economics or political barriers dictate local production.Jh In 36 of 117 cases, joint ventures or sharing arrangements involved chiefly technology development or exchange. In addition to merging complementary

products

and technologies,

Teece,

Pisano

and Russo

note the importance of higher development costs, in combination with shorter life cycles, on the organization of R&D. Rapid technological change in telecommunications has substantially incrcascd the risk of investing in long-lived plant and cquipmcnt, since further technological change rcndcrs prior investments obsolctc. As product lift cycles shorten,

risk-taking

in innovation

is further

intcnsificd,

timing in the commitment of Iargc ilIllOllntS of dcvclopmcnt process bccomcs cvcn more crucinl.J7

since the prccisc rcsourccs

to

the

So, in order to rcalizc scale economics by cxp;uiding geographically, to match complcmcntary products and IUD skills, and to spread the risks of rapidly changing, high-cost technology, most tclccomnlunications firms arc forming joint vcnturcs, collaborative arrangcn~cnts ilIld strategic partnerships.

As wc will explain in the next section, the RI ICs

arc notably absent from (or on the pcriphsrics mainly bccausc of the lint-of-business rely

or1

their suppliers,

of) thcsc dcvclopmcnts,

restrictions.

Instead they must

many of whom arc, or will bc, foreign firms.

Verhxl re1ution.sberweetl carriers utd eqrripttletu vetrdors As noted earlier, heavily on R&D,

tclccommunications cquipmcnt manufacturers spend scvcral times, on avcragc, what tclccommunications

services companies spend. Even BT

and NIT,

which spend a considcr-

ably higher portion of revenues on R&D than do the RlICs, spend less than their suppliers. This raises the question of the locus of innovation activity and the role of upstream suppliers. Tclccommunications scrviccs reprcscnt an acute case of ‘upstream’ products constituting a critical aspect of the user’s process technology. Because users understand

their own needs bcttcr than their suppliers,

WC would expect them to bc active in the product innovation

business. If

one user accounts for a large share of the market for a particular product, it may have considerable inccntivc to innovate. If, altcrnativc-

451bid. pp 38-39. ?bid, pp 35-37. 47Kline and Rosenberg, p301. “‘Nelson. op cif. Ref 31,

op cit. Ref 43,

p 19.

TELECOMMUNICATIONS

ly, the technology is quite gcncral, the user may bc content to communicate product modifications to upstream suppliers, relying on competition in that industry to make this a low-cost mode of suppl~.~” But even when no single purchaser constitutes a large share of the total, so that the inccntivcs for innovation lit more with the suppliers, thcrc arc still plenty of reasons for upstrcam-downstrcam R&D cooperation.

POLICY

April 1990

In many

cases innovation

occurs

in

the process

of modifying

119

Divestiture and regulamry policies

new equipment to the particular needs of the user. The user may also need to modify other aspects of its processes or products to take advantage of the potentialities afforded by new materials or equipment. In such cases, upstream and downstream R&D are complementary. The firm’s own R&D enables it to take maximum advantage of the R&D done by others.” Even though the RHCs may have incentives for upstreamdownstream R&D cooperation, there are appropriability problems inherent in such arrangements. The transactional problems inherent in small numbers and opportunism are dampened somewhat by the prospect of long-term supplier relations. Even so, an RHC may not be able to control the manner in which equipment suppliers deal with their actual or potential competitors. What do these factors, taken together, imply for the RHCs? They have, first, a strong interest in achieving as much compatibility among as many alternative suppliers as possible, to avoid potential lock-in problems of becoming dependent on one or a few vendors. Second, they need a high level of knowledge about the offerings of equipment vendors, in order to keep up with rapidly changing technologies; that requires in-house (including Bellcore) know-how and some joint R&D with upstream suppliers. Third, as long as Bellcore and the RHCs are strictly limited in their ability to appropriate the bcncfits of their own R&D, they have a strong inccntivc to bc as open as possible. Bellcorc’s efforts to dcvclop system standards and scrvc as clearing-house for vendors’ product offerings will almost surely increase the rate and dcgrcc of spillovcr among cquipmcnt makers. These factors collcctivcly Icad the RI ICs to foreign mnnufacturcrs of tclccommunications cquipnicnt. Both through incrcascd pUrCtlilSeS of their products, through the testing, evaluation and design services of Bcllcorc and the individual Rf-ICs, and through joint R&D ventures (cg f’acific Bell and NIX), divestiture has been a real boon for foreign Moreover, Judge Grcenc has cnsurcd that the equipment producers. foreign vendors will gain a disproportionate share of the bcncfits of joint vcnturcs with RI ICs by restrictions placed on foreign business waivers.s” While liberalization of tclccommunications politics is occurring elscwhcrc, it seems highly unlikely that foreign markets will open nearly as fast or as much as the US market has. The most one could hope for is a reduction in the favouritism shown to national suppliers by other nations’ PTTs.

Effects of public policies In previous sections we considcrcd the cffccts of the divestiture itself on R&D and innovation by the Rf ICs. We turn now to the implications of the line-of-business restrictions imposed by the MFJ for the RHCs’ incentives, organization and probability of success in R&D activities. Although not part of the consent dccrec, we also discuss the implications of the FCC’s Open Network Architccturc rcquiremcnt (in the Computer Inquiry III decision) and the treatment of R&D cxpenditurcs by state regulatory commissions under rate-of-return regulation. Effccls of lh ?bid,

p 26. 5oUS District Court, Civil Action 62-0192, Order Issued 26 June 1986.

120

line-of-hlisitlc.~.s rcstrictiom

The line-of-business restrictions (LOBRs) arc intended to prevent the RHCs from exploiting their market power in local exchange access to

TELECOMMUNICATIONS

POLfCY

April 1990

Divestiture

and regularory policies

compete unfairly in related markets. The court has been willing to approve waiver requests for business activities that do not have a high degree of ‘relatedness’ to the RHCs’ core business and has eliminated the structural separations requirements from such waivers.5’ But of principal concern here are the continuing restrictions on RHC involvement in manufacturing or enhanced information services. While these limits may provide incentives for other parties (eg potential enhanced services vendors) to invest in R&D, we are interested in the effects of the limitations on the RHCs’ incentives for, and on the returns to, R&D expenditures. On three main counts, we think the restrictions will have strong negative effects on innovation: 0

0

0

“Order in Civil Action No 82-0192, 10 September 1987. ‘with the exception of the independents, including GTE, which are not bound by the MFJ. Those companies serve only 15% of US telephone subscribers, however.

TELECOMMUNICATIONS

POLICY

They prevent the use of (and thereby discourage efforts to develop) innovations that exploit economies of scope in central office switches. They decrease the incentive for RHC investment in R&D by curbing the appropriability of R&D results (by reducing the scope of applicability in commercialization). They lower the odds of successful innovation by inhibiting ‘learning by doing’ and ‘learning by using’.

While the second effect concerns only the RHCs, the first and third also affect other actors (cg by making joint vcnturcs with manufncturcrs difficult, each potential joint venturer 10~s some of the potential bcncfits of learning by using). Before expanding thcsc points it is important to note that the LOBRs are not only organizational restrictions: they do not merely limit the SCOPC:of RHC activities. They are - first and foremost - limits on the use of technology. A switch that is capable of offering both 10cal xccss and cnhanccd information services could bc used anywhcrc clsc in the world, but not in the USA, so long as the LOBRs are in place.” The LOBRs effectively ‘force’ technology up (to the tandem switches of the IECs), down (to the CPE and PBXs of customers) or sideways (to the equipment of third-party providers). Of course the MFJ cannot control all technology - only its application in the USA. Since the PITS of the world have a dcfinitc interest in integrating as much functionality into the switch as possible, the MFJ has set the USA on a course distinctly different from - if not directly at odds with - the overall path of technological change. Given that PTT’s are fully integrated between local and long distance and across ‘basic’ and ‘enhanced’ services, they have fundamentally different interests than the RHCs in the international standards now being developed. They will, moreover, play an influential - if not detcrminativc - role in that process. We expect the PITS to use their leverage to support standards that favour integration of the network, as opposed to the disintegrated approach being pursued in the USA. If they succeed, the most we can hope for is that technological gains abroad will have limited transferability to the USA (and vice versa). The worst outcome is that, due to a standards impasse, the USA finds itself at odds with world standards. Another effect of the LOBRs is on appropriability, and thcrcby on the incentives for R&D by RHCs. It is widely appreciated that a company,

joint

venture

or research

cooperative

can maximize

return

on

its R&D investment only if it can commercially appropriate a sufficient amount of value from innovations produced by that investment. The

April 1990

121

Divestiture

and regularory policies

LOBRs make it difficult for an RHC to commercially appropriate any innovation that relates to the design of new telecommunications equipment or information key ingredient tions:

complementary

While

services.53 This

in appropriating

is ironic, since the RHCs

returns to innovation

hold one

in telecommunica-

assets.5J

the generally accepted model of innovation

proceeds linearly

from scientific research to development, development to production and production to marketing5’ we agree with Kline and Rosenberg’s ‘chain-link

model’ of innovation.

innovative

process; interaction

tion, distribution understanding.5h

and

In their view, feedback is critical to the among research, development,

marketing

all

generate

produc-

knowledge

and

The LOBRs, of course, greatly limit the amount of feedback by prohibiting manufacturing activity and inhibiting joint ventures with manufacturers.

The

PTTs

are not thus limited,

vertically intcgratcd into manufacturing, collaborative research and joint ventures

however;

while few are

they arc heavily involved in with equipment manufactur-

ers. Indeed, that is one major benefit of the historic practice of each P7T buying mainly from its nationally favourcd supplier: it gcneratcs the feedback and appropriability bcncfits of q”;lsi-integratic)n (while also denying themselves the bcncfits of international competition). The point is not that the RHCS would bccomc heavily involved in manufacturing if the LOBRs wcrc rcmovcd; in all probability they would not. But removal of the restriction would certainly gcncratc il much higher lcvcl of joint coll;lboration

bctwccn

R&D RI ICS

and other forms of joint vcnturcs and

tclccornn~unic~itions

illltf

cquipmcnt

IllilIllIf;IctlI~c~S.

Bcllcorc

has dcvotcd substantial

rcsourccs

to work on open network

architccturc (ONA), particularly the ‘Intclligcnt Network’ (IN/Z) conccpt that is the heir apparent to the ‘Fcaturc NoddScrvicc Intcrfacc’ model.

In large measure

it was this model that captured the FCC’s

imagination in the Computer III proceeding and rcsultcd in the ONA regime being handed down as the law of the land.” While it is critically important

to the RHCs,

Bellcore

is hypcrscnsitivc

because they do not want IN/2 implementation

about this

to become

a

work

quid

either for structural separation rclicf under the Computer regime or for line-of-business relief in the divestiture procccding.sx

quo

53Markey and Blau. op cif, Ref 22. p 5. 54David J. Teece, ‘Profiting from technological innovation: implications for integration. collaboration. licensing and public policy’, Research Policy, Vol 15, No 6. December 1986, pp 288-290. 55Masahiko Aoki. ‘Why and how is interfirm, inter-disciplinary R&D cooperation developing in Japan?‘, paper presented at Stanford University Conference on New Technologies and New Intermediaries. June 1987, p 10. %Kline and Rosenberg, op cit. Ref 43. “‘ONA views and plans: Bellcore’. Telecommunications, January 1987. p 63. %A.M. Rutkowski. ‘The national forum on fntelligent Network/2’. Telecommunications. June 1987, p 68. 59Up cd, Ref 57, p 63.

122

pro

111

While the RHCs all support this work on ONA, thcrc arc significant differences among them. IIcnce, it is reported that ‘each intends to project its own unique related identity . . . [so] Bcllcore’s official position is one of substantive neutrality on most visible ONA issues’.” Thcsc dual forces, the need for standardization combined with a desire for RI IC independence, are driving the technology process. While Bcllcore has been working to dcvisc a stable, universal set of functional macros’ in a highly flcxiblc components which scrvc as ‘network distributed network architccturc, each Rf-IC is seeking to bc individually distinctive. Again, public policy is imposing constraints on technology, not mcrcly on the scope of organizations’ activities. In combination with the LOBRs, ONA is setting the USA on a technological course that is quite different from the rest of the world. In the nations with intense R&D efforts by MTs and telecommunications equipment manufacturers, the

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April 1990

Diveshue

innovation systems

process is directed,

solutions.

Even

and regularory

policies

at least in large part, towards integrated

where

competition

is now

allowed,

nations are not restricting their PTTs or their technology telecommunications services.

other

in providing

Rate base regulation Although Bellcore is not itself regulated as a common carrier, its budget is nonetheless subject to regulatory scrutiny by the state public utility commissions

In some cases RHC

(PUCs).

payments

to Bellcore

been disallowed by PUCs on the grounds that Bellcore’s research strays too far afield from local telephone service.60 In California, allowing

for example,

$30 million

the Public Staff Division

have

applied

proposed

of Pacific Bell’s roughly $100 million

dis-

contribution

to Bellcore. Similarly, a National Association of Regulatory Utilities Commissioners study raised questions about $115 million of operating company support for Bellcore, contending that the primary beneficiaries

of

Bellcore

applied

companies.“’ There are important

research

implications

are

equipment

of this treatment

manufacturing

of R&D

expendi-

tures by the PUCs. First, it explains much of the uncertainty that Bcllcore employees arc rcportcd to fcel.h’ Second, given that oversight by PUCs, it would be imprudent for the RHCs to publicly express dissatisfaction with Bellcorc’s rcscarch, since state regulators might USC such statcmcnts to justify disallowances and rate reductions.

Conclusions The divcstiturc of the Bell operating compnnics has not only altered the structure of tclccommunications in the USA. It has fundamentally shift4 the course of technological dcvclopmcnt. The divcstiturc and conditions imposed by the MFJ on the RI-ICs have rcduccd the incentives for RJIC R&D by restricting the appropriability of innovations.

The

vertical

disintegration

of the RHCs

from

manufacturing

greatly reduces the feedback between R&D, manufacturing and marketing that is often critical to successful innovation. Perhaps most importantly,

the MFJ,

along

with

ONA,

has set the course of US

technology on a trajectory that is quite different from - if not at odds with - the path that other nations will probably follow. On the other hand, divestiture has set off a great wave of competition among

equipment

makers,

especially

those

vendors

attempting

to

replace - if only partially - AT&T as il supplier to the RHCs. There are abundant signs that this competition has been healthy for AT&T itself, as pressures from foreign manufacturers entering the US market (and opportunities for AT&T abroad) stimulate much more market-driven product dcvclopmcnt activities. On bal;lncc, it seems that, at least in the short to medium run, divestiture

BO’S~n of Bell Labs: Bellcore binds the regionals together’, Business Week, 2 December 1985, p 106. “Wallich, op cif. Ref 4. p 96. “Ibid.

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had positive

cffccts

on technological

innovation

in

the

tclccommunications industry, cspccially if vicwcd from a global pcrspcctivc. From a nationalistic pcrspcctivc the answer is less clear. Certainly foreign equipment manufacturers arc among the biggest winners and - so long as the lint-of-business restrictions remain in place _ the RHCs are among the biggest losers. The lesson of all this, unfortunately, is how littlc thought was given to these dynamic, technological considerations in the MF_t decision and

April 1990

123

Divestiture

und regulatory

policies

concomitant public policy debates. Even accepting the proposition that vertical and horizontal disintegration of AT&T produced static efficiency gains by promoting competition and driving prices towards costs, there remains an open question as to the costs of divestiture in terms of dynamic efficiency. The only advice we offer at this junction - specific policy recommendations aside - is that the court, the FCC, the state PUCs and perhaps ultimately Congress itself elevate the importance of technology and innovation in the policymaking and implementation processes. One step in that direction is a transfer of jurisdiction over telecommunications policy from the District Court to regulators. Under antitrust standards it is highly unlikely that technological innovation and national competitiveness will receive the weight they deserve in that decisionmaking process. Under the public interest standards of regulation, there is some chance they will.

Bibliography Amuul Review of Bell Cotnnwnicaiions Researcfl. 1986. Frank Barbctta and Leonard Heymann. ‘Bcllcore asking suppliers to shnrc evaluation costs’, Efecrronic News, Vol 32, No ISXR. IO Fchrunry 19%. ‘Bcllcorc: defining ths information age’, lIt*ll C~~rtirtr~oriccrfiorrs Resclrrcfl ( 19s7. ‘KIICs: Grcenc ruling blunts ONA incentives’, Woe \V&, 21 Scptcnibcr 19X7. pp t-2. ‘Southwcstcrn dcnics stake in l’sumtmi Icd to dccrcc violation’. Hoc Week, 1-t Scptcrnlxr 19x7, pp Y-10. W;dtsr G. Bolter, cd, 7i~lecornrr~iofic~ariotrs I’dicy For 1%~ IWh: The Trumirion IO Cmtrperirion, Prcnticc-I Iall, NJ. IYXJ. John Friar and Mel I lorwitch. “I’hc emcrgcncc of technology stratcg:Y: ;I new dimsnsion of !.tr;itcgic nianu~cmcnt’. ‘l~c/mo~o.gy ... in So&y. Vol 7. 19XS. pp 133-l 7X: tlcrbcrt 1. Fusfcld and Carmcla S. I Iaklixh. ‘Cooncrative R&D for compcfitors’. ffurvurd flttsirlrss f
124

15 June 1987. pp 87-89. ‘A conversation-with Thomas Edrington, Pacific Bell’s technology chief. fucific Bell Undate. 6 Anril 1987. Howard V: Perlmubcr and Dltvid A. Hcenan. ‘Coopcratc to compete globally’, Harvard Bminexs Review. hlarch-April IYXh, pp 136-152. Johnnie L. Roberts. ‘Crowing competition among the rcgionals is changing for whom this hell tolls’. LVaN Streer /ownuf, 8 April 19x7. p 6. Nathan Rosenhcrg. ‘Problems in the economist’s conccptualization of technological innoxttion’, in f’rrspcctivrs WI Teci~mtlo~y , Chapter 4, pp 61-8-l, Camhridgc University Press. 1976. David J. Tcccc. ‘I‘cchnological change and the nature of the firm’. in Dosi. Freeman, Nelson, Silvrrhcrg and Soctc, cds. Tecfwicul Cfrange aml Economic Theory, Pintcr Publishers. London IYXX. David J. T’cscc. ‘The markrt for know-how and the cfficicnt intcrmitiomil transfer of Icchnology’, Ar~md~ of r/w A PSS, No 45X, Novcmhcr 19X1. pp XI-Oh. ‘Fujitsu edging toward entry of class 5 CO switch markst’. Trlepi~orry, 8 June 1YH7, p 2X. ‘Industry casts skeptical cyc on Fujitsu’s switch market entry’. Telepi~otty, 27 April 1987, p 26. ‘SW Bell crcats R&D group’. ‘/kdqd~otry, 6 April lYX7. p 2X. US .Dcpartmcnt of Justice, ‘I~inc-of-business waiver quests suhmittsd to department of Justice pursuant to section VIII(C) of Modification of Final Judgment’, X May 1987. Lawrence J. Whits, ‘Clearing the Irgal path to coopcmtivc rcscarch’, Technology Review, July lY85. pp 3Y-44.

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April 1990