Production Studies Imply Smart Regulation Can Create Prosperous Telecoms and Prevent Bubbles

A review of production function research with telecommunications data shows strong scale economies, which is supported by more recent advances in production function econometrics. Newer economics of reputation and competition shows that both moral hazard and adverse selection problems are present with competition. We show that government-ordered deregulation since late 1970s and the ultimate break-up of the Bell System in early 1980s was based on blind faith in competition, ignored cost savings induced by strong scale economies and was Pareto inefficient. The pseudo competition imposed by the FCC and the courts has not only led to huge excess capacity and losses in the telecom sector, but also fuelled the mindless expansion of dot-com companies. To solve the problem, we suggest permitting further telephone company (Telco) mergers till no more than three firms remain (oligopoly) and making them subject to smart and flexible regulation of prices, quality and rates of return. The paper shows how smart regulation can retain higher quality of service, wider options and low prices to consumers and still minimize monopolistic abuses of pricing power or wasted inputs. Smart regulators should use demand analysis, analysis of complaint data, focus groups, and other sophisticated analytical tools by devising expert panels, public hearings and the Internet. We also propose patent-type reward to encourage true innovation paid by a raise in regulated rate of return. The proposed ad hoc advisory panels should seek detailed analyses by engineers, accountants, bankers, lawyers, computer scientists, and economists but avoid courts