Viewpoints : Cellular Telephone Blues

Cellular telephone use is booming. Every month, more than 10,000 customers are activated in the Los Angeles area alone. This growth has produced enormous profits for cellular service wholesalers, but has not reduced Los Angeles-area service prices, which remain the highest in California.

Last week, the California Public Utilities Commission could have forced these rates down, but refused to do so. This is curious economics and even more curious public policy.

Cellular service is a fixed-cost business. Most of the expense occurs during the initial construction of the network; ongoing operations and maintenance costs are relatively low. Once the break-even point is reached, every additional customer is extremely profitable.

Consequently, the growth in cellular customers has caused profits to soar. Estimates of profitability are imprecise, but the Cellular Resellers Assn., which represents retail service providers selling directly to the public, says the two Los Angeles-area service wholesalers, PacTel Cellular and L.A. Cellular, earned 82% and 119% on their investment in 1988. In comparison, Pacific Bell’s 1988 return on investment was roughly 13%.

In competitive markets, profits this high are virtually unachievable because new companies step in and cut prices--and therefore profitability--to win customers. However, the wholesale segment of cellular service is a duopoly. Because only two wholesalers of cellular service are permitted in any given region--a decision made by the Federal Communications Commission--new competitors cannot step in.

The two existing wholesalers operate without the threat of new service providers entering the market and cutting prices and are thus completely insulated from real or potential price competition. In contrast, the retail market for cellular service is very competitive, with many providers--such as Cellular Service Inc. and California Cellular Communications--and no restrictions on new competitors.

The following chart compares the 1989 wholesale service prices of the providers in three of California’s largest markets.

Notice the pattern. Further, these prices haven’t changed since 1984, despite a dramatic increase in profits for cellular wholesalers. Clearly, there is no competition in any of these markets, a consequence of the duopolistic market structure.

The appropriate response to monopoly power is some form of price regulation or control. This is how we check the monopoly power of other utilities, such as Southern California Edison and Pacific Bell.

The PUC is empowered to regulate prices for cellular service and could force price reductions. However, until only recently, the commission has virtually ignored prices for cellular service, thus enabling the remarkable profits of the wholesalers.

Their profitability has not gone unnoticed by investors. Noting the industry’s growth potential, lack of regulation and favorable economics, an investment research report by Goldman, Sachs & Co. says: “Cellular communications as an economic enterprise has some of the most attractive characteristics of any business . . . (While cellular telephone service is not an unregulated monopoly, it) is a duopoly, which is almost as good.”

The prospect of a near monopoly with virtually no regulatory price controls has encouraged an investor feeding frenzy for cellular service providers, as most recently evidenced by McCaw Cellular Communications’ record-setting bid for Lin Broadcasting.

The PUC has just concluded an investigation into cellular-service pricing. Disappointingly, the commission--in a ruling issued Wednesday--refused to reduce prices. The cellular service wholesalers’ extraordinary profits will continue.

The PUC argued that the profits are necessary to attract the capital needed to expand the cellular network. This rationale is not without some validity. It is true that the network needs capital to improve service quality and expand capacity. The high profit potential attracts investment capital that would otherwise be invested elsewhere.

However, what the PUC missed is that the level of profits need only be higher than that achieveable in competing investments, adjusted for risk. Excessive profits lead to speculation and misallocation of resources. The tremendous speculative run-up of cellular property values, as demonstrated in McCaw’s purchase of Lin, is precisely the result of excessive monopoly profits.

Instead of reducing prices to eliminate monopoly profits, as the PUC does with other public utilities, the commission in this instance chose to ignore their existence. Consumers are stuck.

The PUC disingenuously claims to be supportive of consumers because the decision permits cellular telephone companies to volunteer to decrease prices. When was the last time you remember a company reducing prices voluntarily?

Without any competitive or regulatory pressure, prices will not decrease. And prices should decrease. The Cellular Resellers Assn. estimates that wholesale cellular service prices could drop by roughly 40% in Los Angeles and 20% in San Francisco and still leave wholesalers with enviable profits.

The PUC decision contains statements to reassure us that it is, in fact, working on behalf of the consumer. In a bold assertion, commissioners say they “are not inclined to permit carriers to keep profits due solely to a failure to compete in a duopolistic market.” Yet the PUC has done exactly that by ignoring the spectacular profits of the wholesalers and refusing to order lower prices.

The issue of competition gets to the root of the problem with this decision. While the PUC has espoused the virtues of competition, it has ignored the fundamental reality that the duopolistic wholesale market for cellular service can never be competitive. As long as the commission clings to this flawed notion of competition, cellular customers are likely to pay exorbitant prices for service. Sadly, the commission has missed an opportunity to balance business concerns with consumer interests.

MARKET WHOLESALE ACCESS PEAK OFF-PEAK CARRIER CHARGE RATE RATE $/month $/minute $/minute Los Angeles PacTel Cellular $34.41 $0.370 $0.222 LA Cellular $34.41 $0.370 $0.222 San Francisco GTE Mobilnet $30.50 $0.380 $0.160 Bay Area Cellular $30.50 $0.380 $0.160 Sacramento PacTel Cellular $15.30 $0.206 $0.123 Sacramento Cellular $15.30 $0.206 $0.123