Telephone Cost Allocation: Testing the Variability of Costs

Abstract

insuring an orderly transition from a past environment in which regulatory and judicial rulings dominated to a selectively regulated industry highly influenced by market forces. One of the more controversial telecommunications issues concerns whom should be responsible for the costs of the local exchange plant. A simple recommendation is to assign these costs to users who have caused the costs. For the telecommunications sector, this recommendation is somewhat difficult to implement. Defining telephone costs and services requires an in-depth understanding of complex technology, engineering design, and regulatory history. The telecommunications cost allocation issue is an important one. On one side, local telephone firms argue that basic service has traditionally been priced below cost while toll service (along with other services) has been priced above cost. This cross-subsidization has allegedly been a result of recovering certain costs by usage charges rather than by flat end-user charges. On the other side, regulators and others are concerned whether costbased pricing will mean the demise of universal service. In brief, the costing/pricing debate in telecommunications involves issues of market structure, cross-subsidization, customer bypass, plant utilization, cost efficiency, and system design. Our principal objective is to examine the validity of the present categorization of local ex hange plant costs into traffic sensitive (TS) and non-traffic sensitive (NTS) components. There are pricing implications flowing from this assessment. For example, a decrease in the estimate of NTS costs that are indeed invariant to usage justifies decreasing the access charges now levied on telephone subscribers. There are three basic steps in the allocation of local exchange plant: (1) the categorization of plant costs into TS and NTS components; (2) the allocation of TS and NTS plant costs to the interstate jurisdiction (with the intrastate jurisdictions absorbing the residual); and (3) the allocation of residual TS and NTS plant costs to services within the intrastate jurisdictions. The FCC has mandated that the interstate allocation of TS and NTS plant costs be made in accordance with the criterion of cost causation. TS costs are allocated on the basis of usage. The allocation of NTS costs is more controversial due to multiple interpretations of economic cost causation. Similar issues arise with respect to the allocation of local exchange expenses; however, this research focuses on local exchange plant costs. It is conventional wisdom that the costs allocated to the NTS category are, in fact, not sensitive to traffic variation. As such, the standard of cost causation dictates that NTS costs be assigned to access, i.e., they become one of the bases for flat monthly subscriber charges. Furthermore, as long as demand for access is less sensitive to price changes than usage (either local or toll), telephone companies have an incentive to increase NTS costs by shifting costs from toll to basic service.