AT&T Divestiture

"What Killed Ma Bell?"

MA BELL, the world's biggest company and largest private telephone system, went to her Eternal Reward on January 1. Although she was reincarnated as a new, slimmed down AT&T and seven regional holding companies, the successors to the old Bell System will be vastly changed from the giant telephone company which was such an intimate part of American life for most of this century. The most significant changes are the separation of AT&T from the Bell operating companies and the introduction of increased competition in the telephone field. Most of us who believe in free market economics think the change will be beneficial.

But before we say a last farewell to Ma Bell, we should at least hold a post mortem to find out the true causes of her demise. What killed Ma Bell? Why did she have to die? How did her terminal condition arise?

Some believe the Bell System was brought down by the U.S. Justice Department. The Justice Department had wanted to break up AT&T for a long time and had first attempted it with a 1949 civil suit. While that lawsuit had been settled by a 1956 Consent Decree which left AT&T virtually intact, a second Justice Department suit filed in 1974 was more successful and resulted in the dramatic divestiture settlement which was announced on January 8, 1982 and carried out two years later.

Another hero of the AT&T breakup is Federal Judge Harold Greene, who presided over the case and inserted some of his own convictions in the settlement - such as the order divesting the new AT&T of its lucrative Yellow Pages operation. Perhaps it was Judge Greene's unfriendliness that convinced AT&T management to accept divestiture rather than even harsher terms in a final ruling later on.

Finally, Ma Bell may have been partly done in by her critics. The Bell System had made a lot of enemies over the years. TV comedians like Joan Rivers roasted the telephone company before audiences of millions, while crusaders like Ralph Nader lashed out at the system in books and articles. None of this helped a company that craved and needed the public's support and good will.

It's true that all of these forces played a part in Ma Bell's demise. Yet the real cause of her demise may have been her long status as a "regulated natural monopoly." While this regulation may have appeared to be Ma Bell's great strength, it was also a weakness that proved fatal over time. And in the 1960s, a number of serious problems developed which AT&T was not equipped to solve under the old status.
 

The Key to the Problem

Perhaps the key to understanding Ma Bell's illness and demise is in a little-known but important book entitled Bureaucracy, by Ludwig von Mises. ¹ First published in 1944 and largely reflecting Mises' experience with governmental bureaucracies in Europe, the book shows why bureaucracy is necessary for certain types of organizations and why it becomes harmful or ineffective for other types of organizations. Unlike those who merely denounce bureaucrats, Mises had a sympathetic understanding of bureaucracy as "a method of management which can be applied in different spheres of human activity." He noted that bureaucratic methods are a necessity for handling the apparatus of government, and that what people consider as an evil is not bureaucracy as such, "but the expansion of the sphere in which bureaucratic management is applied." ²

Mises defined bureaucratic management as "management bound to comply with detailed rules and regulations fixed by the authority of a superior body." But business management, on the other hand, is management directed by the profit motive.³For a profit-seeking organization, "success" is not whether the organization closely follows certain rules and procedures, but whether it is profitable.

In the United States, however, many private companies-while still profit-seeking organizations-have been driven toward bureaucratization by government interference of one type or another. The most bureaucratic types of private organizations are those whose prices or activities are regulated and those who engage in a great deal of government business or depend on the government for the right to carry on their business. In a sense, many of these private businesses have to serve two masters: they must be profitable, and yet they must carry out rules and regulations which might inhibit their ability to compete. They are, to quote Mises, expansions of "the sphere in which bureaucratic management is applied."

The Bell System was a victim of bureaucratized management, although it was a privately owned corporation and operated on a profit-seeking basis. But its profit-seeking activities were carefully monitored and restrained by authorities. Bell was subject to three of the four methods which, Mises noted, government authorities apply to interfere with the "height of profit" in private companies: 1) The profits that a special class of undertakings is free to make are limited; 2) The (government) authority is free to determine the prices or rates that the enterprise is entitled to charge for the commodities sold or the services rendered; and 3) The enterprise is not free to charge more for commodities sold and services rendered than its actual costs plus an additional amount determined by the authority either as a percentage of the costs or as a fixed fee. (Not applicable to Bell's case was the fourth method described by Mises, which allows the enterprise to earn as much as it can, with taxes absorbing all profit above a certain amount ⁴
 

Bureaucracy

A private business is doomed if its operation brings losses only and no way can be found to remedy this situation. Its unprofitability is the proof of the fact that the consumers disallow it. There is, with private enterprise, no means of defying this verdict of the public and of keeping on. The manager of a plant involving a loss may explain and excuse the failure. But such apologies are of no avail; they cannot prevent the final abandonment of the unsuccessful project.

It is different with a public enterprise. Here the appearance of a deficit is not considered a proof of failure. The manager is not responsible for it. It is the aim of his boss, the government, to sell at such a low price that a loss becomes unavoidable.

LUDWIG VON MISES

Most private companies encounter some political interference with their profit-seeking activities. But public utilities and defense contractors usually receive the most direct controls because, to a certain extent, they owe their existence to government favors. In the case of the Bell System, this government control went back more than 70 years, and it set the company up for serious trouble when changes came in the late 1960s.
 

The Leadership of Theodore N. Vail

Bell's venture into bureaucratized management started in the 19071919 period under the leadership of Theodore N. Vail, whom Bell people revere as the architect of the modem system: "Alexander Graham Bell invented the telephone, but Theodore N. Vail invented the Bell System," Bell people have said. ⁵

What Vail invented was a unique way of organizing the system under private ownership while getting government approval of the concept of a "natural" monopoly which should be operated "in the public interest." A number of competing telephone systems had blossomed in the early part of the century, and in some cases people served by one system could not be connected with people hooked to another in the same area. To Vail, this was wrong and inefficient, and he apparently did not believe that market forces would solve this problem. Moreover, the most serious threat to AT&T was not competition from other companies; it was the threat of being taken over by the federal government to be run as an arm of the Post Office. This was a very real concern, and in view of the fact that other major countries ended up with government-owned telephone systems which often performed badly, we owe Vail a great debt for keeping the U.S. telephone industry in private hands.
 

No Friend of the Market

But Vail was no friend of the free market or of competition. A distinguished business philosopher, he produced a number of essays and speeches which show that he clearly favored using the power of government to help him reach the goals he sought for the telephone industry. "One Policy, One System, Universal Service," was his emphasis, and he also said, in 1911, that a "public utility giving good service at fair rates should not be subject to competition at unfair rates." ⁶

This seemed a reasonable idea in a time when the public was indignant about the profits of huge corporations and trusts. The concept of giving good service and accepting only "fair" rates in return seemed to show remarkable restraint. It also seemed reasonable to accept government regulation. Vail noted in a 1915 speech that the telephone was considered a necessity: "Society has never allowed that which is necessary to existence to be controlled by private interest." But he defended the monopolistic aspect of the Bell System because of its efficiency and devotion to service and the public interest, and he felt that regulation would work well provided men "of the highest standard" could be appointed to the regulatory bodies for life, with careful provisions made to safeguard their independence from corporate or political pressures. ⁷

Although Vail's beliefs appeared wise and sound, any present day student of business and government would know he was not talking about the real world of commerce and politics. For one thing, "fair rates" sounds marvelous in a speech, but it becomes elusive when regulatory officials actually try to make rate decisions. Few subjects today are more controversial than the rates charged by public utilities, and "rate hearings" by state commissions are sometimes the scenes of near-violent demonstrations with frequent heckling and name-calling.
 

No Government Body Can Be Free from Political Pressures

It is also unrealistic to believe, as Vail apparently did, that any government body can be free from corporate or political pressures. What he idealized, of course, was a statesmanlike group that would make profoundly wise decisions in the public interest and without the aim of benefiting or penalizing any part of society. As we know, however, all regulatory bodies are subject to pressures of various kinds, to say nothing of the convictions and prejudices held by individual members. And even lifetime appointments do not make people "independent" as Vail wanted them to be. For one thing, persons on lifetime appointments always know that their status, if necessary, can be changed by public vote, and they are also vulnerable to other public sanctions.

Still, it is to Vail's everlasting credit that his prescription for the Bell System did work well for many years. AT&T built what was considered the best telephone system in the world. Bell System officials usually won cooperation from federal and state officials and were left free to manage the telephone business in most important ways. They carried out their mission of service with great skill, and they also took care not to flaunt their monopoly position. The telephone operator was always pleasant and helpful, the service truck always arrived promptly, and Bell people would go to any lengths to get systems working again when there was storm damage.
 

Technical Advances

Moreover, the system moved ahead on the technical front, and we came to expect frequent improvements: rotary dialing that eliminated need for calling the operator, direct dialing of long distance, WATS service, and better telephones. With a system that covered more than 80 per cent of the nation's telephones, Bell could do extraordinary things to get long distance calls through when circuits were busy in certain areas. With service like that, why would anybody want a different kind of telephone system?

But trouble was never far away from the Bell System. One of the prickliest matters was Bell's ownership of Western Electric, the manufacturing subsidiary that produced most of the equipment for AT&T. A plus-$12 billion-a-year business in 1982, Western Electric had long been under attack. Indeed, it was to force the divestiture of Western Electric that prompted the U.S. Justice Department's 1949 civil suit against Bell. To AT&T, Western Electric was a necessary part of its operations and helped it to assure a high quality of service. To others, it was simply another manufacturer that was able to maintain a government-sponsored monopoly position because the 22 Bell operating companies were captive to it and had to buy most of their equipment from Western Electric. Some believed that Bell officials manipulated Western Electric's bookkeeping, and the like, to produce tax advantages for the company. Whatever the facts, there was no denying that Western Electric held a monopoly position that simply wouldn't have existed in a nonregulated environment. This was a festering issue with companies that had the expertise and technology to compete with Western Electric, but were denied entry to the market.

More serious trouble came for the Bell System as a result of its ratemaking and costs policies. In 1934 Congress passed the Communications Act which gave the newly formed Federal Communications Commission jurisdiction over AT&T (although state regulatory bodies also controlled the local Bell companies). According to a recent AT&T publication, the Communications Act "put into law the long-standing AT&T principle of providing universal telephone service at reasonable cost. One result was to subsidize lower residential rates by raising the cost of long distance service and business services-an action that set off a continuing controversy in the ensuing years." ⁸
 

The Achilles' Heel

This rate-setting policy, seemingly an advantage in the 1930s, became the Bell System's Achilles' Heel in the 1960s. It also shows, more than almost anything, how far the Bell System had been able to stray from the usual constraints that face business organizations in the marketplace. No business with competitors can deliberately reduce its prices to one group of customers while making up the difference by overcharging other groups. This would be certain to bring at least two undesirable effects: 1) There would he excess demand for the underpriced commodities or services, bringing additional losses to the business, and 2) competitors would swoop in to capture the overpriced part of the business, making the original pricing strategy unworkable.

But Ma Bell could adopt such a pricing policy because of the telephone company's monopoly position, which the government protected. Company officials knew that certain parts of its markets were tempting targets for potential competitors. But both Bell policy and public policy, backed by the police power of government, kept raiders out of these markets. More than almost anything, this policy showed how responsive the Bell System was to political moods and trends. The practice of holding down residential rates and overcharging long distance users was really a subtle form of the "soak the rich" policies that had come to dominate government thinking in the 1930s. It is also true that residential users, as a group, command more votes in state and federal elections than do long distance and business users. What the rate policy really meant is that long distance and business users were being taxed, with Ma Bell as the collector, to subsidize residential service. This gap became very large over time. An Ohio Bell official said early in 1983, "We're collecting, on the average, about $12 a month for basic local service from each residence customer. The gap between this $12 price and the $25 cost is currently recovered from other services priced considerably higher than their costs." ⁹

This unusual rate-making policy might have continued virtually unnoticed for a number of years except for two developments. One, the FCC in 1968 issued its famous "Carterfone" decision which opened the way for business and residential use of interconnecting equipment. Then, aided by new technology, a company called MCI was given FCC authority to proceed with long distance services in a selected market. A 1978 federal appeals court decision later upheld MCI (and others) in serving long distance customers, previously a Bell fiefdom.
 

The Bell System's Dilemma

Critics of the Bell System approved of these moves and there was widespread agreement that it was about time AT&T faced some "real competition." Dismayed AT&T officials tried to fight back by accusing competitors of "cream skimming," i.e., taking the most lucrative markets and ignoring other telephone services. This is the same argument the government uses to protect its monopoly on first-class mail, and it actually has merit. It really is not fair to place one organization under tight control, with bureaucratic management, and then suddenly expose it to competition from other firms who are free to select their markets. Mises would have understood the Bell System's dilemma immediately: It was following pricing (or rate-making) rules that had been worked out over time by public authorities. Its assignment had been to promote widespread use of an essential necessity, the telephone. It carried out this mission and then, abruptly, FCC and federal court decisions brought a radical change in the rules.

It's hard to say what the long-term effect of these new rules will be, but it's clear that the Bell System was already being devastated by competition even before the 1982 divestiture announcement. A large number of all new business installations were non-Bell, and MCI and Sprint have captured part of the long distance market. Competitors' shares of both long distance and business markets could balloon to enormous size unless AT&T is able to counter this competition.
 

Lack of Flexibility

Meanwhile, the Justice Department in 1974 had again filed suit to force the divestiture that has now taken place. AT&T Chairman Charles L. Brown noted that Bell - which had been barred from entering the computer field by the 1956 Consent Decree - faced a "fence with a one-way hole in it"- a hole that admitted Bell's competitors but did not permit the company to compete back. ¹⁰It's also true that the Carterfone and MCI decisions were of the same order. Bound by regulation and excessive rules, the company simply did not have the flexibility to strike back at these new competitors in the way any lean, marketing-oriented company is likely to do.

Even without divestiture, giant AT&T would eventually have come to grief if it had attempted to continue under close regulation while new competitors plucked away at its choicest markets. For one thing, where would it have found the revenues to continue subsidizing residential service? And how could it have elevated residential rates to reflect their true cost when these matters are controlled by state public utility commissions? The company was in a no-win situation, and Bell officials were glumly aware of it.

What killed Ma Bell? Well, a number of forces moved against her in the end: competitors, critics, the FCC, the Justice Department and federal courts. But she really passed on because her method of management - the bureaucratic management that is useful for public institutions - is ill-suited for competitive battles. From the sound of their advertising and the restructuring they're undergoing, AT&T and the new Bell offshoots are becoming more attuned to the demands of the marketplace. They'll need to become attuned. There are lots of hungry competitors out there who want a piece of the action, and there will be dramatic shootouts in pricing, services and technology.

People who hail the new competition in the telecommunications field should not be too critical of Ma Bell in her era of monopoly. Her performance and service were marvelous compared with the performance and service of government-owned telephone systems elsewhere. If the choice is only between a government-owned, government-operated enterprise and a private, profit-seeking enterprise regulated and controlled by government, the Bell System record seems to say that the latter is better.

The mistake, which both the public and Bell accepted, was in believing that anybody should be granted a business monopoly enforceable by law. It's true that the early telephone industry appeared chaotic and inefficient when two telephone systems in the same area could not connect with each other. In short order, however, the needs of the customers, merger, or improved technology would have overcome this problem. And "natural" monopolies, to the extent that they exist, become outmoded. The railroads, for example, once had a monopoly on fast overland transport; this was quickly bypassed by the trucking industry in the 1930s. In the same way, the telephone companies' natural monopoly on service in a given area may soon be bypassed by a profusion of new technologies.

The 22 Bell operating companies, which will continue to be regulated under the umbrellas of the seven holding companies, may have trouble maintaining their position when new methods of bypassing them are marketed. AT&T itself, with its prestigious Bell Laboratories, Western Electric, and Long Lines may become a strong competitor in pushing these new technologies. But its protected, captive market is gone.

Ma Bell was a grand old lady in her day. We might agree with Art Buchwald, who called her "the only monopoly I ever loved." But we wouldn't really want her back.

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At the time of the original publication, Mr. Barger was a corporals public relations representative and writer in Toledo, Ohio.

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1 Ludwing von Mises, Bureaucracy (Cedar Falls, Iowa: Center for Futures Education, 1983; N.Y. 1969; an unaltered, unabridged reprint of the 1944 Yale University Press edition).

2 Ibid., p. 44.

3 Ibid., p. 45.

4 Ibid., pp. 65-66.

5 Alvin von Auw, Heritage & Destiny (New York: Praeger Publishers, 1983), p. 5.

6 Theodore N. Vail, Views on Public Questions, 1917. A privately published collection of writings and speeches.

7 John Brooks, Telephone (New York: Harper & Row, 1975, 1976), p. 144.

8 AT&T Communications, a pamphlet published by the new AT&T to explain the divestiture and the services it will offer in the future, p. 6. From AT&T, New York.

9 W. E. MacDonald, The New Ohio Bell in the Age of Information, Speech before Toledo (Ohio) Rotary Club, February 28, 1983.

10 Alvin von Auw, p. 29.

Reprinted with permission from The Freeman, a publication of The Foundation for Economic Education, Inc., April 1984, Vol. 34, No. 4.