I. I I I I I Iii; Wises!“ ll”, Hi 1 ll 1 LIBRARY Wm I'll }’ Ititlllllll Michigan State University This is to certify that the dissertation entitled DIRECT COMPETITION IN CABLE TELEVISION DELIVERY-- THE MONTGOMERY, ALABAMA AND PARAGOULD, ARKANAS EXAMPLES presented by Marianne Barrett has been accepted towards fulfillment of the requirements for I Ph.D. degree in Mass Media $7M Major professor Date f/Iié] MSU is an Affirmative Action /Equal Opportunity Institution 012771 PLACE IN RETURN BOX to romovo thlo ohookout from your rooord. TO AVOID FINES rotum on or botoro doto duo. DATE DUE DATEDUE DATE DUE a ) g3“ 59 Oct "-.FEB 0 6 ‘99‘ EB ) 1}}??? . a ’ '1 g i ‘ ,_; I A $41 , 415?;g (PT A n! 02 I” 3W? “‘8’ $1059} A A1 m1 DIRE THE MONT in Com DIRECT COMPETITION IN CABLE TELEVISION DELIVERY-- THE MONTGOMERY, ALABAMA AND PARAGOULD, ARKANSAS EXAMPLES BY Marianne Barrett A DISSERTATION Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Communication Arts and Sciences - Mass Media 1993 DIRE TEE MONT Cablei consideredl the long m challenged' 0f competit' constraint! "natura1- an effort Wt of con Cable Telev 1992, In 1 of Rates, C a means of technology As or could be f0 StatQS. ABSTRACT DIRECT COMPETITION IN CABLE TELEVISION DELIVERY-- THE MONTGOMERY, ALABAMA AND PARAGOULD, ARKANSAS EXAMPLES BY Marianne Barrett Cable television in local markets has historically been considered a natural monopoly with competition infeasible in the long run. However, this has been successfully challenged in the courts. Some scholars argue that the lack of competition in local markets is due more to artificial constraints placed on would-be entrants than on any "natural" characteristics of cable television delivery. In an effort to rein in an industry that is widely viewed as out of control, on October 5, 1992, Congress passed the Cable Television Consumer Protection and Competition Act of 1992. In its policy statement and Section 623, Regulation of Rates, Congress stated its preference for competition as a means of "promoting a diversity of views through multiple technology media". As of October, 1992, direct head-to-head competition could be found in about forty communities in the United States. Through case studies of Montgomery, Alabama and Paragould, Arkansas, this dissertation takes a microanalytic approach to the issues associated with direct competition in cable television. This dissertation determines which of the market conditions that the literature suggests impact competition occur in these situations and which of these conditions also outlin of competit The ca‘ Montgomery cable operat response to engaged in p attempt to pl entrant to 3 also address Competition reSilltecl in SUbSCribers. Vhich this c likelihood o the Clissel-ta conditions are the most critical to successful entry. It also outlines additional factors that affect the feasibility of competition in cable. The case studies consider the political climate in Montgomery and Paragould as it relates to entry by a second cable operator, examine the behavior of the incumbent in response to entry by a rival, assess whether the incumbent engaged in price cutting, entered into litigation in an attempt to prevent entry and/or attempted to subject the entrant to stringent franchise requirements. The studies also address how the entrant has reacted, on what dimensions competition has occurred, and whether this competition has resulted in improved service and/or lower prices for subscribers. Finally the studies determine the extent to which this competition has been successful, and assess the likelihood of its continuation. One of the objectives of the dissertation was to gain information that can be applied to other markets and used to address public policy. Copyright by MARIANNE BARRETT 1993 TO RAY The at encourageme Baldwin, cc His guidanc successful Specia advice gin Additicnal . Department . Committee f< 311th” is a] TelECOmmuni the completj Thanks Ph'D‘ pr°9ra This di Md t0 prOVij appreciated ACKNOWLEDGMENTS The author is especially appreciative of the encouragement, support and generosity provided by Dr. Thomas Baldwin, committee chair and director of this dissertation. His guidance throughout the entire Ph.D. program made the successful completion of this degree possible. Special thanks is also expressed for the dedication and advice given by Drs. Bruce Allen and Bonnie Reece. Additional thanks to Dr. Barry Litman, chair of the Department of Telecommunication and member of the guidance committee for his continuing understanding and support. The author is also indebted to the Department of Telecommunication and ITS Lab staffs for their assistance in the completion of this dissertation. Thanks also to Todd Simon, Director of the Mass Media Ph.D. program. This dissertation would not have been possible without the cooperation of the people of Montgomery, Alabama and Paragould, Arkansas. Their willingness to be interviewed, and to provide documentary information is greatly appreciated. vi BY 1 also cont degree . Fina Bryn prov entire pr: By providing worry-free childcare, the Womble family also contributed significantly to the completion of this degree. Finally, the author's husband, Ray Pernot and daughter Bryn provided balance and a sense of normalcy throughout the entire process. For that and so much more, thanks. vii CHAPTER II III IV VI VI I CHAPTER II III IV VI VII TABLE OF CONTENTS LIST OF TABLES INTRODUCTION Rationale for the Study NATURAL MONOPOLY THEORY Economies of Scale Subadditivity Sustainability and Contestability REVIEW OF THE RELEVANT LITERATURE Empirical Studies of Overbuilds Cable Television and Natural Monopoly Theory CASE LAW FRANCHISE POLICY STRATEGIC BEHAVIOR Price Setting Product Differentiation Long-run Barriers to Entry METHOD PAGE xii 10 12 17 17 21 3o 42 57 571 62 __ as CHAPTER VIII IX CHAPTER VIII IX ix MONTGOMERY Market Characteristics Political Factors Strategic Behavior Price Competition Customer Service Program Offerings Impact of Competition in Montgomery PARAGOULD Market Characteristics Political Factors Price Competition Customer Service Program Offerings Strategic Behavior Issues Associated with Municipal Ownership Impact of Competition in Paragould PAGE 79 79 8O 91 98 105 112 114 119 119 121 152 158 162 165 179 183 CHAPTER CHAPTER CONCLUSIONS Market Characteristics Political Factors Strategic Behavior Litigation Miscellaneous Delaying Tactics Price Competition Customer Service Program Offerings Impact of Competition Outlook for Competition Further Research PAGE 191 191 193 194 194 195 196 197 198 199 201 208 xi PAGE APPENDIX A 214 Communities with Competing Cable Systems APPENDIX B 217 Original List of Communities with Competing Cable Systems APPENDIX C 221 Paragould, Arkansas Ballot Question June 17, 1986 APPENDIX D 222 Arkansas Code Subchapter 6 Television Signal Distribution Systems APPENDIX E 223 Arkansas Local Government Bond Act APPENDIX F 225 Paragould, Arkansas Ballot Question October 31, 1989 LIST OF REFERENCES 226 Articles and Papers 226 Books 235 Court Cases 236 Interviews 238 Public Documents 240 Miscellaneous 243 TABLE TABLE LIST OF TABLES Basic Cable Rates U.S. vs. Montgomery Paragould City Cable Monthly Rates for Service Paragould Cablevision, Inc. Monthly Rates for Service Paragould Cablevision, Inc. Basic Service Rate History Basic Cable Rates 0.8. vs. Paragould Average Monthly Revenue Per Subscriber U.S. vs. Paragould xii PAGE 102 149 150 153 154 187 Cable considered the long 1 Challenged W SChOIars a is due mo: entrants t televisior an industI federal 9C October 5' Senate vot Television (3'12). I Regulation coInDQt i t i O \ i A“ e I‘91 Es C,- CHAPTER I INTRODUCTION Cable television in local markets has historically been considered a natural monopoly with competition infeasible in the long run. However, this has been successfully challenged in the courts in cases such as Prererred WWW‘ . some scholars argue that the lack of competition in local markets is due more to artificial constraints placed on would-be entrants than on any "natural" characteristics of cable television delivery. Additionally, in an effort to rein in an industry that is widely viewed as out of control, the federal government began to reregulate cable television. On October 5, 1992, both the House of Representatives and the Senate voted to override President Bush's veto of The Cable Television Consumer Protection and Competition Act of 1992 (8.12). In Section 2, Policy Statement and Section 623, Regulation of Rates, Congress stated its preference for competition as a means of "promoting a diversity of views 1 Ange1e§r_§e1r 754 F.2d 1396 [1985]. 1 through viabilit programua nonexclu: As c could be States.‘ as an "ov 'cable te systems 11 area."5 2 through multiple technology media."2 To further the viability of that competition, the Act contains access to programming requirements and encourages the granting of nonexclusive franchises.3 As of October, 1992 direct head-to-head competition could be found in about forty communities in the United Statesu‘ This type of competition is commonly referred to as an ”overbuild” and is defined as a situation in which ”cable television service is offered by two or more cable systems in direct competition within the same service area."5 2 o 1.. ’ ‘ ‘ _:,'l '!:-‘!L' . ',TC '! 1!! 'UP‘ '9, AQ§_QI_122ZI sec. 2 and 623, "Statutory Supplement Public Law 102-385." Ui_§l_§2de_Ann2tated (December 1992)- 3 Mary Lu Carnevale, "Congress Clears Cable TV Bill; Veto Expected," The Well srreer gegrnel, September 23, 1992, A3 and A4. "Bush's Veto of Cable Bill is Overturned," I The_flall_§treet_12urnal. October 6. 1992. A3 and A6. ‘ See Appendix A for a list of markets in which there is competition among cable television operators. 5 "Cable Television Regulation", W 70:2, February 1991, 36. There are essentially five types of overbuilds: 1.) an independent owner/operator of a few systems competing against a similarly-sized rival. An example of this is Monroe, Michigan where Blade Communications and James Cable partners operate competing systems. 2.) an independent owner/operator competing against a large multiple system operator (mso) . Montgomery, Alabama where Montgomery Cablevision competes with Storer/TCI is this type of overbuild. 3.) a mso competing with an mso. There are no examples of this at the present time and it is widely believed that there is a "gentleman's agreement" between msos that they will not overbuild one another. 4.) a city-owned system competing with a large mso. Niceville, Florida which is about to begin construction of its municipal system in competition with Time-Warner Cable is an Althc all cable that giver. Economist interactio franchises and the re market con. Smiley as . are intens 3 Although overbuilds exist in less than one percent of all cable franchises, the fact that there are any suggests that given certain conditions competition is possible. Economist Albert K. Smiley modelled the competitive interaction of two cable operators with overlapping franchises and found that both the degree of overbuilding and the resulting welfare effects are highly sensitive to market conditions.6 .Among the market conditions cited by Smiley as impacting competition in cable television delivery are intensity of demand, the ability of the entrant to differentiate its product from the incumbent, the cost of cabling the community and the strategic interaction between firms. Additionally, the entrant should anticipate that the incumbent will act to thwart that competition. One overbuilder suggested that it is market conditions in combination with political forces that determine the extent to which competition between cable operators is feasible.7 Through case studies of the Montgomery, Alabama and example of the fourth type of overbuild, and 5.) a city-owned system competing with an independent operator. Negaunee, Michigan where the city competes with Bresnan Communications is an example of this. 5 Albert R. Smiley, "Direct Competition Among Cable Television Systems," Discussion paper 86-9, Washington DC: U.S. Department of Justice, Antitrust Division, Economic Analysis Group (BAG), June 5, 1989, 2. Smiley also noted that the feasibility of competition is dependent on whether entry occurs simultaneously or sequentially. 7 Harry P. Cushing, III, President and CEO of Telesat Cablevision, Inc., telephone interview by author, Lansing, Michigan, September 1, 1992. Paragoul licroana competit. answering 1.) h 0 V U! V \30‘ V t l C I it E d I 4 Paragould, Arkansas markets, this dissertation takes a microanalytic approach to the issues associated with direct competition in cable television. The studies focus on answering the following research questions: 1.) Which of the market conditions outlined in the literature as favoring competition exist in ”real world" situations? 2.) Which of these factors seem to be the most critical? 3.) How does the political climate impact competition? Specifically do the franchising authority's policies encourage competitive entry? 4.) On which of the following dimensions does competition occur? Price? Service? Programming? .) What has been the response of the incumbent to competition? How has the entrant countered that response? What has been the effect on consumers? Specifically, have prices for cable service decreased? Has service and/or programming improved? 8.) Is competition likely to continue in the long-run? \lOt 01 0 0 vv In Montgomery, an independent operator is overbuilding an established multiple system operator. In a preliminary interview, Rush Rice, President of Montgomery CableVision, stated that the key issue faced by his company is litigation in federal court against the anticompetitive behavior of Storer/TCI, the nation's largest multiple system operator (mso).8 Montgomery illustrates some of the market and political factors that are evident when two operators compete in a single geographic area. ' Rush Rice, telephone interview by author, Lansing, Michigan, August 31, 1992. Specifically, Storer/TCI sued the City of Montgomery over two ordinances, one which limits price competition and the other which prohibits the company from entering into exclusive program contracts with cable networks like ESPN. Montgomery CableVision joined in the lawsuit on behalf of the city. Pa: municipa Paragon] has beer. March, 1 of compe basis of Amendment The status of which an municipal, prOVide CE W The c. because it 5 Paragould, Arkansas is one of the few examples of a municipal overbuild of a private operator. The City of Paragould through its Commission of Light and Water (CLW) has been competing with Cablevision Systems, Inc. since March, 1991. The issues associated with municipal ownership of competitive cable systems include legal challenges on the basis of antitrust, the due process clause of the Fourteenth Amendment, and the First Amendment. The history of the Paragould case and the current status of the overbuild illustrate the type of behavior in which an incumbent engages to thwart competitive entry by a municipality and the legal conditions under which a city can provide cable television service in competition with a private company.9 W The case study was chosen as the method of inquiry because it enables the researcher to take an in-depth approach to complex issues. Competition in cable television is particularly well-suited to this method. In an article on franchise bidding in cable television, economist Oliver E. Williamson quoted from Bauer and Walters: the complexity, instability and local variation of many economic phenomena imply that the establishment or understanding of relationships requires that analysis be supplemented by extensive observation and also that the inquiry must often extend beyond statistical 9 The 1992 Cable Act has a provision which expressly allows a municipality to own and operate a cable system in competition with a private operator. info- sour Thoma researcher advice anc study appzl process ir 19705, G. Process in the Sacran °Verbui 1 ds 6 information to direct observation and use of primary sources.1 Thomas W. Hazlett, arguably the most widely published researcher on competition in cable, followed Williamson's advice and examined two duopolistic markets using the case study approach. Williamson's case study of the franchising process in Oakland, California in the late 19608 and early 19703, G. Kent Webb's 1983 study of the franchise bidding process in Philadelphia, and Hazlett's 1987-1988 study of the Sacramento, California and Orange/Dada County, Florida overbuilds are the only academic studies that have used this method to examine cable television. To date, only Hazlett's study has looked at overbuilds. He believes that there will be an increase in direct head-to-head rivalry between cable operators because of the increased availability and acceptance of pay television that improves an operator's internal cash flow and enhances the operator's ability to secure the external financing necessary to support the development of overbuild franchises; the lack of availability of new franchises as the majority of the U.S. becomes wired: and the increased cost of purchasing an existing system as opposed to constructing a new one.1 While much of the case law and other research concerning cable overbuilds, both municipal and private, w Oliver E. Williamson, "Franchise bidding for natural monopolies--in general and with respect to CATV" Ihe_fie11 lenrnal.ef_fieen2mic§ 7:1 (Spring 1976). 101 and 102- " Thomas W. Hazlett, "Cabling America: Economic Forces in a Political World" in W Cento Veljanovski, ed. (London: Institute of Economic Affairs, 1989), 215. focuses o. concentra. associate: in local 1: theory. C competitic summarizes Status of outlines f feaSibilit tYpe of St oligopolis of the met ChaDters v, I and Paragm the findim further re; 7 focuses on first amendment issues, this dissertation concentrates on the economic and political factors associated with direct competition between cable operators in local markets. Chapter II discusses natural monopoly theory. Chapter III reviews the literature which examines competition in cable television delivery. Chapter IV summarizes the case law concerning the natural monopoly status of cable television in local markets. Chapter V outlines franchise policy and discusses how it affects the feasibility of direct competition. Chapter VI details the type of strategic behavior one is likely to see in oligopolistic markets. Chapter VII discusses the specifics of the method used to answer the research questions. Chapters VIII and IX report the results of the Montgomery and Paragould studies respectively. Chapter X summarizes the findings, offers conclusions and suggests topics for further research. The t complex. economic t . exce Concepts 5 of scale , °°ntestabi addressed EC0710111183 \- ECOHO' average CO increases.‘ CHAPTER II NATURAL MONOPOLY THEORY The theory of natural monopoly is contradictory and complex. In the words of economist Harold Demsetz, ”the economic theory of natural monopoly is exceedingly brief and . . . exceedingly unclear."1 'There are four critical concepts associated with this theory. They are: economies of scale, including size, density and scope: subadditivity, contestability, and sustainability. Each concept will be addressed in turn. Esonemies.ef.§eale Economies of scale refer to cases where the long-run average costs of producing a product decline as output increases.2 Economies of density are a distinct type of economy of scale and are particularly relevant to cable television delivery in local markets. Hazlett defines economies of density as "scale economies where volume is measured on a per mile or per number of homes passed basis ‘ Harold Demsetz, "Why Regulate Utilities?” legrne1_er .Law_and_Ecen2mise 11: April 1968. 56- 2 Edwin Mansfield, , Fourth Edition, (New York: W.W. Norton & Company, 1983), 228 and 229. Bruce T- Allen. Managerial_322nemiee. (New York: Harper 8 Row Publishers, 1988,) 275. rather scope r differe their p firm." outputs Convers is rate TESpect premium Channel multipr, Hal natural the PrE: noted. ‘ natural Charact, e“1y t1 Scale a1 9 rather an on an absolute size standard."3 iEconomies of scope refer to "the simultaneous production of several different outputs in a single enterprise, as contrasted with their production in isolation, each by its own specialized firm.”‘ ‘When a firm produces those several different outputs simultaneously, it is known as a multiproduct firm. Conversely, a firm which produces only one output at a time is referred to as a single product firm. For example, with respect to cable television, when an operator provides premium services such as Home Box Office and the Disney Channel as well as a package of basic services it is a multiproduct firm and enjoys economies of scope. Many who argue that cable television delivery is a natural monopoly in local markets base their contentions on the presence of economies of scale. However, as Sharkey has noted, while the presence of such economies may suggest a natural monopoly, "one important extension to [the characteristics of natural monopoly as developed by the early theorists] is the realization that simple economies of scale are neither necessary nor sufficient for natural 3 Thomas W. Hazlett, "Private Monopoly and the Public Interest: An Economic Analysis of the Cable Television Franchise.” MW 134: 1335. 1986, 1364 note 104. ‘ William J. Baumol, John C. Panzar and Robert D. Willie. Q2ntestable_Earkete_and_the_The2rx_9f_Industrx Strnernre (New York: Harcourt, Brace, Jovanovich, Inc., 1982), 71. mono; authc indus In fa if a more "most impos simpl ECO n . 13410111. 10 monopoly."5 .Additionally, he points out that not all authors agree that natural monopolies are primarily in industries in which there are pervasive economies of scale. In fact, "some have noted that there can be natural monopoly if a single firm can produce more efficiently than two or more firms in the absence of economies of scale."‘ .And, "most authors have recognized that it is difficult or impossible to label a given industry a natural monopoly by a simple measure of economies of scale."7 Hazlett writes, nearly a century ago , the existence of economies of scale was established by some theorists at the eine_gge pen of natural monopoly. While such economies are sometimes still cited by regulators to justify certain public utility and other regulatory arrangements, the economic literature no longer recognizes such economies as logically necessitating the existence of a monopoly.8 Subadditixitx Subadditivity is a concept that is closely related to economies of scale. To Sharkey and others, it is subadditivity rather than economies of scale that is necessary for a natural monopoly to exist in a particular 5 William W. Sharkey, (Cambridge: Cambridge University Press, 1982), 15. ' Ibid., 20. 7 Ibid. 8 Hazlett, "Private Monopoly and the Public Interest: An Economic Analysis of the Cable Television Franchise,” 1340 and 1341. Iarket. produce 1 combinat: defined 1' the effic industry. is necess Producer , (emphasis outcome 01 °°mPetitic Posn relevant rather the "°“°P°ly. it SUch a firms will failures, “3°11ch S that 50 lo demand mos 11 market. Subadditivity is present when a single firm can produce the desired output at a lower cost than any combination of two or more firms. "Natural monopoly is then defined in terms of a single firm's efficiency relative to the efficiency of other combinations of firms in the industry."9 Further, "for the monopoly to be natural, it is necessary that a single firm remain as the most efficient producer 1; the restrictions on competition are removed." (emphasis added) And, "natural monopoly is itself the outcome of the competitive process under ideal competition."10 Posner has written, "if the entire demand within a relevant market can be satisfied at lowest cost by one firm rather than by two or more, the market is a natural monopoly, whatever the actual number of firms in it." And, if such a market contains more than one firm, either the firms will quickly shake down to one through mergers or failures, or production will continue to consume more resources than necessary.11 In either case, Posner asserts that so long as a single firm can meet the market's entire demand most efficiently, one can be reasonably confident that the market will Shakedown to a single firm, at least if 9 Sharkey, op.cit., 54. 1o Ibido ’ 54-56o ‘1 Richard A. Posner, "Natural Monopoly and Its Regulation," EEQDIQIQ_LQW_B£¥1£!,21= February, 1969, 548. there are merger.12 I to test v unrestric crucial '1 discussed Baum! the subad< Which give Subadditi‘ analytical then suff simp Suba 12 there are no undue inhibitions on price competition or merger.“ Both Posner and Sharkey imply that the only way to test whether a market is a natural monopoly is to give nnreerriereg competition a try. This is a notion that is of crucial importance in cable television delivery and will be discussed at length in the section on franchising. Baumol, Panzar and Willig agree with Sharkey that it is the subadditivity of costs rather than economies of scale which give rise to natural monopolies. They state while subadditivity may be an intuitively appealing concept, it is analytically elusive. In fact, they find that there exist no conditions that are necessary and sufficient for subadditivity that are analytically simpler than the definition. . . To prove subadditivity, we must have information on the costs of eyery potential small or intermediate producer and that is why we must know the cost function of a firm for eyerv v*<=v.13 That subadditivity is so difficult to establish suggests that natural monopolies may be quite rare. anetainabilitx_and_£2ntestabilitx The sustainability and contestability of markets are closely related concepts. Baumol, et. al. describe a sustainable industry configuration as one which has the following properties: “ Ibid., 612. ‘” Baumol, et. al, op. cit., 170, 171. The authors go to lengths to provide some conditions that they consider sufficient and others that are necessary for subadditivity. However, their proofs are beyond the scope of this proposal. For details see Baumol, et. al., 171-186. 1.) in q the yiel than must prof of t In t comprised demonstra; Operates , normal ra. entrants 1 behave in Ifurther. a I ‘°"°poliSt achieVing 13 1.) the quantities demanded by the market at the prices in question must equal the sum of the outputs of all the firms in the configuration: 2.) the prices must yield to each active firm, revenues that are no less than the cost of producing its outputs: and 3.) there must be no opportunities for entry that appear profitable to potential entrants who regard the prices of the incumbent firms as fixed.“ In the case of a natural monopoly, only a configuration comprised of a single seller can be sustainable. But it is demonstrably sustainable if and only if a natural monopolist operates in an efficient manner and earns no more than a normal rate of return on its capital investments.“ Sharkey and Baumol, et. al. rely on the ability of potential entrants to exert pressure on the incumbent monopolist to behave in a manner in which consumer welfare is maximized. Further, Baumol, et. al. suggest that if the natural monopolist is not operating in an efficient manner and/or is achieving supernormal profits, the monopoly will not be sustainable and the market will be contestable.16 A contestable market is one "in which potential competition operates in an ideal form.“7 Although there can be only one active firm in an efficient natural monopoly “ Ibid., 5. ‘5 Sharkey states, "a natural monopoly is said to be sustainable if a price-output pair exists such that the monopolist satisfies all demand at the quoted price, earns nonnegative profits and no rival firm would wish to enter any portion of the monopolist's market." Sharkey, op. cit., 151. 1‘. Baumol, et. al., op. cit., 6. '" Sharkey, op. cit., 14S. market, 11 would be ultimatel produce a outputs d the susta depends t Potential the case °°mP9titj effectiv, Coorsey, Openly a. t° Suppl HowevEr' Should ‘ “01101301: radiCal the Gas 14 market, many inactive firms may exist. These inactive firms would be willing and able to enter into competition with and ultimately replace the incumbent firm if that firm does not produce at the lowest possible cost or produce the set of outputs desired by consumers. The contestability as well as the sustainability of a natural monopoly market then depends to a great extent on the efficacy of the process of potential competition. To Coursey and his colleagues, in the case of contestable markets, potential entry or competition for the market disciplines behavior almost as effectively as would actual competition within the market. Coursey, et. al. assume that at least two firms bid freely, openly and directly for buyer purchases and that the right to supply the market is won by the lowest price bidder.18 However, because the market itself does not function as it should to ensure satisfactory performance, many natural monopoly markets are subject to regulation, a factor that radically reduces the threat of entry by a competitor. In the case of cable television, entry is restricted by virtue of the franchise requirement imposed on would-be operators by municipalities and while operators may bid for the market, they do so not directly to buyers but through the franchise authority. ‘3 Don Coursey, R. Mark Issac, and Vernon L. Smith,"Natural Monopolies and Contested Markets: Some Experimental Results," Wise 27: April, 1984, 92,93. A se the entry without 8 of large sunk if t Productio argued th headend a example, SYStem is hundred ml an inVest; recouped sunk cost lem One contestab lIlhet Cable tel debate. establish Sustainab at least of the in doubtfm : dis‘tribut \ 19 Bar 15 A second requirement for a contestable market is that the entry process be entirely or almost entirely reversible without cost. Sharkey and Baumol, et. al. cite the presence of large sunk costs as one key barrier to entry. Costs are sunk if they cannot be eliminated even with the cessation of ‘9 In the case of cable television, it can be production. argued that those costs are substantial and include the headend as well as most of the distribution network. For example, the average cost of constructing an aerial cable system is approximately $13,500 per mile. A system with one hundred miles of plant is considered small but, represents an investment of $1,350,000, an investment that cannot be recouped if the project is abandoned. These significant sunk costs subsequently become a barrier to exit and would lead one to conclude that cable television delivery is not a contestable market. Whether this should also lead one to conclude that cable television delivery is a natural monopoly is open to debate. Subadditivity may exist but it is as difficult to establish in the cable industry as elsewhere in the economy. Sustainability is questionable because of the willingness, at least in some local markets, of a rival to enter portions of the incumbent's market. The contestability of cable is doubtful because of the large sunk costs associated with the distribution of the service. And, the contestability of w Baumol, et. al. op. cit., 280. cable mar restrict‘ requireme be a mono have beer theory tc the follc 16 cable markets is largely untested because of the restrictions on entry that exist in the form of franchise requirements. Cable television delivery in most markets may be a monopoly, but not necessarily a natural one. There have been several studies which apply natural monopoly theory to this industry. Those studies will be discussed in the following chapter. Ther competiti consists applies n turn. 'f~ M The Structure this mode s"-I'Vice b situation Cited as Studies C One of h]. that in C thEre We] VOuld be Prime“x du0pol 131 l W HOnOpOlya CHAPTER III REVIEW OF THE RELEVANT LITERATURE There are two bodies of literature which examine competition in cable television delivery. The first consists of empirical studies of overbuilds and the second applies natural monopoly theory. Each will be discussed in turn . j The industrial organization model looks at how market structure impacts a firm's conduct and performance. Under this model, the expectation is that price will be lower and service better in competitive versus monopolistic Situations. The electric utility industry is frequently cited as a model of natural monopoly. Yet, there have been sthadies of competition in this industry. For example, in one of his studies, economist Walter J. Primeaux, Jr. found t"-l'lat in cases where there is competition between two firms, tZhere were lower average costs of production than there would be in the absence of competition.‘ In a later study, Primeaux found substantial price differences between du0polistic and monopolistic electric utility markets. \ 1 Walter J. Primeaux, Jr., "Some Problems with Natural "°nopoly." MW. Spring. 1979. 68. 17 18 The marginal price between the 500 and 750 kilowatt blocks is lower by 16 percent, the marginal price between the 750 and 1000 kilowatt blocks is lower by 19 percent and the average price is lower by 33 percent because of competition.2 Only a few studies have empirically tested the effect of competition on price and service in local cable markets. In 1982, John Mansell questioned whether overlapping franchises improved the variety of service offerings or the speed of expanded service introduction over that provided by a single operator. While citing a list of thirteen then current overbuilds, he noted that Allentown, Pennsylvania ”is the single case of a ‘successful' overbuild" and that "the situation has resulted in both companies offering essentially the same service for the same price."3 Further, Mansell contended that the problems associated with overbuilds include signal leakage, disruption of the public domain, such as city streets, construction delays and protracted litigation that may involve the franchise authority.‘ 2 Walter J. Primeaux, Jr., "Estimate of the Price Effect of Competition The Case of Electricity," Beeenreee ADQ_EEQIQY 7. 1935. 338- 3 John Mansell, "Overbuilds and redistricting" in guide , Nancy Jesuale, ed., CTIC Cablebooks Volume II, (Arlington, Virginia: Cable Television Information Center, 1982), 43. ‘ Ibid., 45. The problem of signal leakage that Mansell identified as one of the negatives associated with overbuilds has been significantly reduced as technology has improved. With the increased deployment of fiber optic transmission lines, the problem of signal leakage will become a non-issue. A] little others plentit It franch: Home B: than t] T] partiCl basic ; POSt-r noncom Channe "The c sefvic Additi 19 Although Mansell suggests that the consumer has gained little from competition, at least in the case of Allentown, others have found that rates are below average, channels are plentiful and the service superior.5 In one of his studies, Hazlett found that duplicative franchise systems' rates for basic and the premium service, Home Box Office, were estimated to be $1.82 a month lower than those in monopolistic jurisdictions.6 The 1984 Cable Act largely deregulated cable, particularly the rates that an operator can charge for the basic level of service. Hazlett was the first to include post-regulatory data in a study of prices in competitive vs. noncompetitive markets. He found that prices and prices per channel were substantially lower for overbuilt systems. ”The combined monthly package [of basic plus one premium service] is nearly 24 percent less under competition."7 Additionally, "the price of basic cable in competitive markets dropped by an average of 41.5 percent from their 5 For example see Mark Lewyn and Julie Amparano Lopez, "More Choice for Cable TV?" figeineee_fleek May 13, 1991, 44. The Allentown case is frequently cited as example of the 'benefits of competition in the provision of cable television service. 6 Thomas W. Hazlett, "Competition vs. Franchise Monopoly 1n Cable Television." Q2ntemeorarx_£oliex_lesues Volume IV. April, 1986, 91. 7 Hazlett, "Cabling America: Economic Forces in a Political World," 218. [are-comp.| confirme A 1 found th markets conpetit company versus 4 Ste C .mmmusu measure results dIVQrSe °°mpeti month 1 include °°5t ve “Odel .1 3:3 HUM 20 pre-competitive levels."8 'The studies discussed below confirmed Hazlett's results. A 1990 survey of 52 markets by genegmere;_3eeeereh found that the rates for basic cable in non-competitive markets were 18 percent higher than in comparably-sized competitive markets. Further, in areas where only one cable company existed, fewer channels were provided, on average 33 versus 40, and the cost per channel was 33 percent higher.9 Stanford L. Levin and John B. Meisel used the Qenegmereifleeeereh survey and a matched-sample design to measure the extent to which direct competition in cable results in lower prices, improved service quality or more diverse price-quality choices. They found that customers of competitive cable companies pay between $2.94 and $3.33 per month less for service, and that basic service typically includes more channels. Levin and Meisel also found that cost variables were not significant in any regression model . 1° This may suggest that costs are relatively unimportant factors in setting cable prices, within limits and that cable companies are charging what they can in the market, given customers' demands, and that relatively ' Ibid. 9 John Merline, Dallas Davidson and Evans Pierre, ”How to Get Better Cable TV at Lower Prices,” WEI}. May 1990, 10. in In their models, Levin and Meisel used density (homes Passed per mile of cable) and age (of the system in months) as cost.variables. The cable 0 m (T H l tele seal of s to e com CON mul 'Rol 5y; re EC 21 small differences in cost will not affect the market price.11 The authors conclude that the most effective restraint on cable prices will come from competition. 9able4Ielexision_and.matural_uonoeolx_1heorx The studies that apply natural monopoly theory to cable television delivery focus almost exclusively on economies of scale.“ Little if any attention is paid to the concepts of sustainability or contestability.13 Even with respect to economies of scale, the findings of researchers is contradictory. This may be a reflection of the contradictory character of natural monopoly theory itself. In a theoretical comparative analysis of single versus multiple cable television systems, Rolland C. Johnson and Robert T. Blau concluded that allowing two or more cable systems in a given market to compete house-to-house would result in the unnecessary duplication of services and an economic waste of resources.“ This is because ”most cable 1‘ Stanford L. Levin and John B. Meisel, ”Cable Television and Competition Theory, Evidence and Policy," Ielscommunications_£olicxl December 1991. 525- ‘2 Although the term "economies of scale" refers to economies of size, density and scope, unless stated otherwise, it most often implies an economy of size. ‘3 Although Noam and Owen and Greenhalgh discuss subadditivity briefly, the foci of their work are economies of scale. “ Rolland C. Johnson and Robert T. Blau, ”Single vs. Multiple-System Cable Television," WW 18:3, (Summer 1974), 323-346. televis that so wired t wish tc demand He assert. ECOIlOlIt .4_dnHrfITH 22 television franchises allow operators to construct a system that serves the entire community [and] once the community is wired the system is capable of servicing e11 persons who wish to subscribe." That is, one firm is able to meet the demand of the entire market. Hazlett criticized Johnson and Blau's study and asserted that the economies to which they alluded were economies of density and not scale per se. If we assume [as Johnson and Blau did] that cable is a business experiencing overwhelming fixed cost and trivial variable cost, we must deduce that average cost falls as the number of customers rises against a fixed cost outlay. This indicates that average cost falls as more subscribers are added to the existing system (economies of density). It does not indicate that an existing system can grow to service new areas at a lower cost than that of a new entrant (economies of scale).15 Eli M. Noam used 1980 data from 4200 U.S. systems in an effort to answer the question of whether cable is a natural monopoly. In this study he considered cable a single product firm and used number of subscribers and number of homes passed as his measures of output. Noam found that beyond a small scale, average costs decrease with output and marginal costs are below average costs in the observed range. This implies that large cable operators have cost advantages over smaller ones, that these advantages increase with the disparity in size and, as a result, operate against ‘5 Thomas W. Hazlett, "The Policy of Exclusive Franchising in Cable Television,“ Media 31:1 (Winter 1987), 4. ent: C0111 cri‘ fir. bas sin 480 obs sub pro ecc ecc to fo: the apl as] 23 entry by another single product cable company.“’ Noam concludes "the existence of economies of scale throughout the relevant range of output meets Baumol's sufficiency criterion for a natural monopoly for the single product firm."17 However, because most cable operators provide both basic and premium services, they are multiproduct and not single product firms. Noam later expanded his study to all 4800 systems in operation in 1981. In the latter study, he observed economies of scale for two outputs--basic and pay subscriptions, and noted that because they are larger than product specific economies, they are more correctly economies of scope. To Noam, the presence of these economies suggests a natural monopoly structure. This seems to conflict with his finding of relatively small economies for the output measure, "homes passed" and his statement that "the implication . . . is that scale economies do not appear to exist primarily in the technical distribution aspects of cable television."” Further, the fact that fairly small returns to scale are observed for "homes w Eli M. Noam, "Local Distribution Monopolies in Cable Television and Telephonee Service: The Scope for Competition" M“ - - - Eli M. Noam, ed., (New York: Law and Business, Inc., 1983), 358. '7 Ibid. 'w Eli M. Noam, "Economies of Scale in Cable Television: A Multiproduct Analysis," in , Eli M. Noam, ed., (New York: Columbia University Press, 1985), 106. pa: [ de pac suk to Noa con eco by pro com 198 con 0111: effi int! finc CQnS "e11 24 passed", "suggests that the cost advantages of size are [derived from] the larger operator's greater ability to package and sell his services more effectively to potential subscribers."19 These cost advantages seem to be tied more to the market power of large operators than to the natural monopoly characteristics of cable television delivery. This distinction is critically important. While similar in approach to the studies undertaken by Noam, Bruce M. Owen and Peter R. Greenhalgh drew different conclusions from their work on competition in cable. In an econometric analysis of the cost and demand conditions faced by individual systems, Owen and Greenhalgh used data from proposals submitted in municipal franchise bidding competition across the United States during the period 1979- 1982.20 They found that average costs were approximately constant over city size in the range examined, suggesting only modest economies of scale. While noting that "the effects of city or franchise-area size on costs are interesting,"21 Owen and Greenhalgh also stated that this finding was "not especially relevant to the issue of competition among cable systems. ”22 '9 11616., 113. 2° Bruce M. Owen and Peter R. Greenhalgh, "Competitive Considerations in.Cable'Television Franchising," genremperery Peliex_le§gee Volume IV, April 1986, 69-79. 3 Ibid., 76. 22 11616. ir dc an: w11 V11 Sce ecc 11101", the Cab is tau 1‘ May WQre inSt 25 To see what effect direct competition within a city would have on costs, they used the mean value of all independent variables except subscribersd23 They found that in head-to-head competition, between two cable systems down the same streets, with each system having a fifty percent market share, there is about a 14 percent penalty in unit costs per subscriber. They argued that "although this [the 14 percent penalty] is hardly negligible, it is within the range of monopoly markups that might be expected in the absence of competition or effective regulation."“’ Owen and Greenhalgh concluded that consumers might be better off with competition in spite of the cost penalties associated with the lost scale economies. Noam and Owen and Greenhalgh found small economies of scale but differed in their conclusions as to whether those economies were enough to render the industry a natural monopoly. Part of the discrepancy between the findings of the researchers who have applied natural monopoly theory to cable television delivery is the discrepancy in how output is measured and whether cable is considered a single or multiproduct firm. Depending on the unit of measurement one may or may not find economies. For example, Johnson and ‘3 The independent variables used by Owen and Greenhalgh were number of subscribers, number of channels, miles of institutional network, and miles of wire. The dependent variables were annual total cost and annual cost per subscriber. 2‘ Ibid. , 76. 812 cm in! su‘ 0L1 si nu a] 01 can“ 26 Blau used number of subscribers and concluded that competition would be wasteful. Noam used several measures including homes passed and basic subscribers and pay subscribers. He found only small economies of size when output was measured in terms of homes passed with more significant economies of scope achieved when the measure was number of pay and basic subscribers. Owen and Greenhalgh also looked at several dimensions of output including number of subscribers, miles of wire and numbers of channels and measured the effect of that output on total costs and unit costs per subscriber. Although they found only modest economies of size, Owen and Greenhalgh did find that within a given city, the costs of producing a given level of output are minimized by single-firm production:25 They concluded that neither was enough to rule out the possibility of competition. The fact that output can be measured in more than one way is only one of the peculiarities of cable television. Cable is also peculiar in that if output is measured by homes passed or number of channels, then output is limited by technology and is inextricably tied to plant size.“ :3 Owen and Greenhalgh, op. cit., 78. When this occurs, subadditivity is said to exist. 2‘ If output is measured in terms of number of subscribers, then the operator has more leeway in increasing output without being required to increase plant size but only 'within the range of homes passed. Unl. out; exa ope he / cos cos am; no th Cd In 27 Unlike other industries, the cable operator cannot increase output without at least retooling the physical plant. For example, in a typical coaxial cable system,”'if the operator wishes to add to the number of active channels he/she must replace the amplifiers in the system. While the cost of replacement may be minimal, nevertheless there is a cost. Additionally there is a limit to the number of amplifiers that can be placed in succession before noticeable distortion occurs. Adding channels also requires that receivers and processing equipment be installed at the cable headend.”3 To increase the number of homes passed is even more costly. In addition to technical requirements, expanding a cable system may involve obtaining additional franchises or purchasing adjacent systems. This significantly limits the operator's ability to expand output beyond a certain point and achieve economies of scale. A third peculiarity of cable is that economies of scale are overwhelmingly economies of density. As the number of subscribers per number of homes passed increases, the average cost of providing cable service decreases. This is ”' Although fiber optic technology is increasingly employed in the trunk lines of cable systems, the majority of the plant, that is the feeder and drop lines, continues to be coaxial cable. 23 The headend is the nerve center of a cable system. It is where all channels are received or originated, assembled and processed for transmission by the distribution network. Thomas F. Baldwin and D. Stevens McVoy, 528121.: gemmgnieerien, second edition, (Englewood Cliffs: Prentice Hall, Inc., 1988), 9. Ci ft dc EC BK BIC tt th "t 28 true to varying degrees depending on the level of fixed and variable costs. When Johnson and Blau did their study in the early 1970s, it was fairly safe to assume that most of the cost of cable delivery was fixed. This has become less true with the emergence of costly basic cable networks such as ESPN, CNN, and TNT. While cable continues to have sizable fixed costs, variable costs can no longer be considered an afterthought. Currently variable costs include cost per channel per subscriber, the cost of converters and additional outlets frequently provided at no extra charge to the subscriber, and copyright and franchise fees. This is not to say that there are no economies of density in cable delivery: they remain. But, as variable costs continue to rise in relationship to fixed costs, those economies become less significant. This makes it all the more difficult to convincingly argue that cable is a natural monopoly. Where cable operators do achieve efficiencies is through economies of scope and market power. As noted in the previous chapter, economies of scope can be defined as "the simultaneous production of several different outputs in a single enterprise, as contrasted with their production in isolation, each by its own specialized firm."”' In cable, those outputs are basic and pay channels or subscribers. Noam found significant economies of scope in his latter 2’ See p. 11. study. from t sell h operat W televi render increa should with 1‘. Cable . 29 study. He also found that the cost advantages of size stem from the larger operator's greater ability to package and sell his/her services more effectively than a smaller operator. While there may be some efficiencies in cable television delivery, these efficiencies are not enough to render the industry a natural monopoly. The courts have increasingly found that cable is not a natural monopoly and should be open to competition. The evolution of case law with respect to the natural monopoly characteristics of cable television is the subject of the next chapter. 55 CHAPTER IV CASE LAW The courts, like scholars, have not been unanimous in their determinations of whether cable is in fact a natural monopoly- In Qreater_Eremont1_Incl_xl_§itx_of_£remont (firemenr), two cable operators challenged the validity of the municipal franchise ordinances in Fremont and Sandusky, Ohio.1 ‘While the case did not deal with competition between operators in a single geographic location, it was one of the first to address the question of whether cable television delivery is a natural monopoly. The court found that it was not. In fact, firemen; asserted that cable is capable of carrying as many messages as pairs of wire in the cable can be created. [And] a cable with 12 wires can carry 132 messages at the same time. . . . While practical considerations may limit the number of operators, nonetheless, 132 CATV systems each entirely ‘ Qreater_Eremont_Incl_2l_§itx_of_zremont 302 F- SUPP- 652 [1968]. 30 31 independent of all the others could in theory be carried in a cable the size of one's thumb.2 MWW (Benlger), an incumbent operator brought an antitrust suit against the city.3 The city attempted to restrict the operator from expanding its system for a period of three months as the city examined proposals from potential competitors. While the central issue in the case was whether the city was exempt from antitrust laws, Judge Markey in his dissent considered the natural monopoly question. On appeal, the city's sole defense is to pretend, disingenously and contrary to the extensive, uncontradicted testimony and the specific findings of the trial judge and contrary to its own City Attorney's advice that cable is a "natural monopoly". Not to put too fine a point on it, that argument is today simply fallacious. As the trial judge found and as the record makes clear, modern technology makes free and open competition both practical and economically 2 Ibid., 657, Note 5. The court arrived at the number 132 from the formula: number of pairs = n x (n-l), and used 12 pairs as an example. A distinguishing characteristic of firemen; is the fact that neither operator intended to erect his/her own transmission system. Each proposed using the facilities of the Ohio Bell Telegraph Company. In many cases where the courts examine the question of whether cable is a natural monopoly, the defendant, usually a city, argues that franchising more than one operator will result in undue disruption of public rights of way. 3 MW: 630 F. 2d 704 [1980] (U.S. Court of Appeals 10th Circuit). l Qi;y_] presel exist: been i Indiar H'r‘lmnrrt-rmmnu-n_: 32 available to the city by at least four competing cable communicators.‘ Writing for the court in Qmega_§atellite_£roduct§_xl Qit2_of_lndianspoli§ (omega). Judge Posner relies on the presence of economies of scale as a requirement for the existence of a natural monopoly but notes that it has not been established that those conditions are present in Indianapolis.5 The cost of the cable grid appears to be the biggest cost of a cable television system and to be largely invariant to the number of subscribers the system has. Once the grid is in place . . . the cost of adding another subscriber is probably small. If so, the average cost of cable television would be minimized by having a single company in any geographic area: for if there is more than one company and therefore, more than one grid, the cost of each grid will be spread over a smaller number of subscribers and the average cost per subscriber and hence price will be higher. If the foregoing accurately describe conditions in ‘ Ibid., 712. 5 Qmege_§atellite_2r2ducts_Qol_xl_£itx_2f_lndianaeolie 694 F. 2d 119 [1982]. In this case, Omega was seeking a reversal of a lower court's denial of a preliminary injunction which would forbid the city from removing Omega's cable from a drainage culvert. Omega brought action against the City of Indianapolis contending that the city violated the Sherman Act by granting defacto exclusive cable franchises. The Court of Appeals found that the denial of the preliminary injunction was proper because Omega "did not establish sufficient probability that it would prevail on its Sherman Act claim and that even if the injunction were granted, Omega was not likely to make a serious effort to enter the cable television business until the merits of its action were determined after trial." Ibid., 120. (E OF se CO in is no of 0f R 33 Indianapolis--...a question on which the record ... is sketchy at best--it describes what economists call a "natural monopoly," wherein the benefits and indeed the possibility of competition are limited. ... [However, in trial] Omega may be able to prove that cable television in Indianapolis is not a natural monopoly.6 (fierkenire), cable operators challenged the requirement that operators construct an institutional/industrial network and set aside channels for public access.7 In its decision the court accepted the natural monopoly argument and used the "economic scarcity" rationale as outlined in W 5 to justify its finding that the contested requirements were legal. The Berkshire court found that the requirements did not constitute a taking of property and.even if they did, cable operators have been given just compensation. Cable operators are given the right to use the streets and other public places to construct their cable distribution systems. . . Cable operators are also gixen a "natural monopoly" over cable television within their service areas.(citations omitted, emphasis added.)9 6 Ibid., 126 and 127. 7 BerEshire_Qeblexiei2n_of_8hode_1§land_xl_fiurke 571 F. Supp. 976 [1983], 989. ' 8W 395 ms. 367 [19691 In Reg Lion, the Supreme Court "relied upon the scarcity of broadcast frequencies when it upheld the constitutionality of FCC regulations (sic) known as the fairness doctrine." Berkshire. 981. ° Berkshire. 989. 34 What is troubling about Berkenire is the court's confusion of a natural monopoly with a legal one. While it is true that an operator may be given a monopoly, in the case of cable television franchising, the monopoly is a legal one, not necessarily a natural one. The Berkshire court's reasoning is also flawed in its assumption that because operators rarely develop competing cable systems within the same service area, a "natural monopoly" results. The court also refers to the economic realities of the cable industry, which as a practical matter, create a "natural monopoly" for the first cable operator to construct a cable system in a given service area.10 Although there may be advantages that accrue to the first operator, these advantages come from being first in the market and should be considered separately from those factors that determine whether a market is in fact a nernrel monopoly. e ' ' s . Incl (Qentral_Telecommunications) is part of a growing body of law that questions whether cable television delivery is a natural monopoly.11 Although the law in this area [right of a local governmental body to place a limit on the number of ” Ibid., 986. 11 Iner 610 F. Supp. 891 [1985], (o.c. Mo.). What whet] by m.- rulir 35 franchises in its jurisdiction] is far from settled, the emerging answer appears to be that the grant of a single cable franchise is permissible only if the physical and economic conditions of the relevant market give rise to a "natural monopoly" situation. What Qentral_Ielecommunicetions suggests is that determining whether cable is a natural monopoly must be done on a market 12 by market basis. An especially interesting case with respect to the natural monopoly status of cable television is Iele; WWW ‘3 In this case. TCI alleged that "there are no legal or practical reasons why two companies cannot compete directly to provide cable television service."“ TCI undoubtedly took the position it did here because the company had been ordered by the Air Force to remove its cables and other equipment from Homestead Air Force Base. In reversing the lower court's ruling and finding in favor of TCI, the Circuit Court twice V Ibid., 899 and 900. '3 WW 757 F. 2d 1330 [1985]. This case involved the provision of cable television service to Homestead Air Force Base in Dade County, Florida. From 1974 through 1983 TCI had an exclusive contract to serve the base. In June, 1983, the Air Force requested bids for Cable. television service from a 'variety of parties and Subsequently granted an exclusive contract to a TCI Competitor. “ Ibid., 1335. In [9 36 echoed TCI's allegation that competition between two operators was possible, at least in this particular case. Perhaps the most important case with respect to direct competition in cable television is Erererre§_§ennnnieeriene LAWN (Preferred) -" While argued principally on first amendment grounds, Prererred has significant natural monopoly implications. Prior to this case, cities and franchising authorities frequently used cable's disruption of the public domain as justification for limiting the number of franchises granted. The Erererreg court found, that although the disruption may legitimately give rise to a need for licensing, it is inconsistent with the First Amendment for a city to limit access to single cable television company . . . when the public utility facilities and other public property necessary to the installation and operation of a cable television system are capable of accommodating more than one system.“ Although the court chose to avoid deciding whether economic scarcity justifies government regulation in the case of cable television, it did accept the plaintiff's assertion that "competition is economically feasible in the " Ibid., 1402. IO In l’U CC TIC 37 Los Angeles area" and assumed "that no natural monopoly exists . "‘7 In both W 5:41.. (W)" and W Q£_§§n:§_§:nz,(firggp_fl)”, the Courts took their cues from Erefierred in rendering their decisions primarily on First Amendment grounds. Although the Century Federal court asserted that it confronted the natural monopoly issue because "the parties have hotly contested the question of whether the cable television market in the proposed service areas is a natural monopoly"“’it didn't really establish whether such a monopoly existed. Instead, the Court in ggn;gzy_figgg;§l chose the course taken by the D.C. Circuit court in Quincy “. That court found that because there is no "meaningful distinction between cable television and V Ibid., 1404. '3 WW 648 F. Supp. 1465 [1986] (N.D. Ca1.). ‘w EIQHD H gable IDQ x 91;! 9f §gg§g grgz 669 F. Supp. 954 [1987] (N.D. Cal.). 2° W. 1472- 2‘ 99W 768 F. 2d 1434 [1985] (Doc. Ciro). [(0 h. 57; 38 newspapers" the natural monopoly rationale for regulation of cable television is irrelevant.22 The Court in firggp_fl, relied heavily on firefigzrgd in justifying its determination that a finite utility infrastructure is not a sufficient reason for limiting to one the number of cable companies allowed to operate in a city. But, the Q;ggp_fl court went a step further and concluded that even if Santa Cruz's factual allegations concerning its cable market are taken as true, [and the market for cable television in its community can only support one cable franchise], the natural monopoly rationale cannot as a matter of law 2Jjustify Santa Cruz's paternalistic regulatory scheme. Finally. in Ea2ifi2_Eest_£able.§9mpanx_xl_§itx_ef W (W).“ a jury found that "cable television in Sacramento is not a natural monopoly and that head-to-head competition is likely to occur and endure in the Sacramento market."25 The Court ordered the defendants to issue to the plaintiff a "license or licenses . . . for the construction and operation of a cable television system 22 Ibid., 1472 and 1473. The principal outcome of Quincy was the striking down of the "must carry" rules. These rules required that cable operators carry all local broadcast channels. 1” 9r932.fl. 964- 2‘ w c' 672 F. Supp. 1322 [1987] (E.D. Cal.). 3 Ibid., 1328. 01’ l 199( por1 impc in t cabl was majo diSs was dete depe SCal. axis. 39 or systems within the defendants' jurisdictions ."u’ As of 1990, Pacific West Cable was providing cable service in portions of Sacramento in competition with Scripps Howard. In its judgment, the Pacific West court noted the importance of the jury's finding If competition is feasible and sustainable, then the impact of selecting a single cable television service provider and then excluding all others has an extremely significant effect on expression . . . the interests identified by the jury are not sufficiently substantial to justify a government-endorsed monopoly over a particular medium of communication, nor is such a monopoly "essential" to the furtherance of these interests . "27 To summarize, the courts have been far from unanimous in their decisions regarding the natural monopoly status of cable television. In Ergmgn; the court concluded that cable was not a natural monopoly. In figulggzL_ although the majority found in favor of the city, Judge Markey in his dissent concluded that cable television in Boulder, Colorado was not a natural monopoly. In ngga Judge Posner said that determining whether an industry is a natural monopoly is dependent on establishing the presence of economies of scale. And, he was uncertain about whether those conditions existed in Indianapolis. In figxkgnirg while the court accepted the argument that cable was a natural monopoly, 2‘ Ibid., 1340. 27 Ibid. , 133s. I'U f . U in Co Co; the 40 that court confused a natural monopoly with a legal one. This suggests that the concept of what constitutes a natural monopoly is not clearly understood. The court in Qentre1_1e1eeemmgnieeeiene stated that while the law regarding the right of municipalities to grant exclusive franchises was far from unsettled, it appeared that the only circumstance under which such policies would be permitted would be in cases of natural monopoly. As noted above, perhaps the most important case with respect to direct competition in cable television is Prefezzege In this case, the court accepted the plaintiff's assertion that competition is economically feasible in the Los Angeles are and assumed no natural monopoly existed. Further, the Preferred court found that as long as its infrastructure can physically support more than one cable system, a city cannot issue an exclusive franchise. To do so would violate the First Amendment rights of would-be entrants. Since Preferred in cases like Qeg;e;y_£egezele_ gregp_fl and Eeeifie_fleet the courts have been quite consistent in concluding that it is only under the most stringent of conditions that a municipality can constitutionally justify a policy of exclusive franchising. By explicitly stating that "a franchising authority may not grant an exclusive franchise and may not unreasonably refuse to award an addit: codif: more < numbe1 impac1 telev: follox 41 additional competitive franchise'fl” the Cable Act of 1992 codifies the decisions of the courts and makes it all the more difficult for cities to justify limiting to one the number of cable operators providing service in a community. Nonetheless, franchise policy will continue to have an impact on the viability of direct competition in cable television service. The reasons why are detailed in the following chapter. 2‘ Cable Act of 1992, Section 623. Op1 an: of Act fra met f re Mor fra mar. nec mar. the Cab the ren. gra: HOD! ”Ont CHAPTER V FRANCHISE POLICY The 1984 Cable Act requires that a prospective cable operator obtain a valid franchise before beginning operation and details the steps to be followed to secure the renewal of that franchise.1 Prior to the passage of the 1984 Cable Act, there was no set of federal procedures regarding franchises. Rather, each municipality developed its own method of determining which company would be given the franchise. Jack Gilbert, General Manager of Storer Cable in Montgomery, Alabama has stated that the reason that franchising policy was allowed to develop in the ad hoc manner that it did was because cable was not viewed as a necessity the way that other utilities were and so was not mandated at the federal or state level.2 Daniel L. Brenner and Monroe E. Price have stated that the franchising process has in large measure shaped the cable television industry and that while there may be 1 While the 1992 Cable Act has a provision requiring the Federal Communications Commission to reform franchise renewal rules, it leaves the rules pertaining to the granting of original franchises intact. 2 Jack Gilbert, General Manager, Storer Cable, Montgomery, Alabama, interview by author, tape recording, Montgomery, Alabama. February 24, 1993. 42 43 competition fer the market, "this competition is aimed at obtaining the franchise from the local authority, rather than by direct competition for the hearts and minds of the ultimate subscriber.3 They imply that this is a poor substitute for competition yighin the market. This is the conclusion reached by many scholars who have examined cable television franchising. In his groundbreaking 1968 article, Harold Demsetz discussed what he considered the deficiencies of natural monopoly theory and argued that although a market may be a natural monopoly, the number of bidders for the market can be quite large. By allowing these bidders to compete for a franchise, the market is forced to behave in a manner that is similar to the behavior one would expect under competition. To Demsetz and others, this process provides an attractive alternative to rate regulation as a means of controlling the natural monopolist's behavior. Under Demsetz's model, the only role that the government or a consumers' buying cooperative would play is to use some random device to select the winning bidder in the case of a tie.‘ 3 Daniel L. Brenner and.Monroe E. Price, erle;1e1exieien, WWW. (New York: Clark Boardman Company, Ltd., 1986,) 3.01, 3-3. ‘ Demsetz, op. cit. ine nat sta pro stu 197 As 1 the trdl app. neg£ deta 44 While conceding that this may involve negotiation between organized buyers and sellers as well as a somewhat uncertain outcome with respect to wealth distribution, Demsetz asserted that "there is no reason to expect inefficiency."5 Although Williamson believes that franchise bidding for natural monopolies may have attractive properties, he also states that, in reality, it encounters many of the same problems that are associated with regulation. From a case study of cable television in Oakland, California done in the 1970s, Williamson concluded that good intentions to the contrary notwithstanding, unassisted franchise bidding . . . conducted and executed under conditions of uncertainty has dubious properties. The franchise authority that assumes an accommodating posture is merely legitimating monopoly while a concerted effort to exercise control requires the agency to a adopt a regulatory posture.6 As he views it, the key problem with franchise bidding is the fact that the process is "beset with numerous transactional difficulties" and is much more complex than it appears at first glance. Unconvinced that this process is necessarily better than regulation, Williamson argues for a detailed examination of additional alternatives. A few years earlier, Posner applied Demsetz's model to 5 Ibid., 58. ‘ Williamson, op. cit., 101. cable that 1 proce: solic: I...“ ~ 1 a H A H H as the franc} Those °NE ar Payne; POSDe: franc} Charac Seek a franch 45 cable television but took it one step further and suggested that the ultimate consumer play a role in the franchising process. Under Posner's model, bidders would be allowed to solicit the area's residents for a period of time. The applicant would seek to obtain actual commitments from potential subscribers. The franchise would then be awarded to the applicant whose guaranteed receipts on the basis of subscriber commitments were the largest. The applicant would also be required to contract in advance that in the event he won, he would provide the level of service and at the rate represented in his solicitation drive.7 Posner offered the model he did because of what he saw as the dangers associated with the long-term exclusive franchising of cable television operators by municipalities. Those dangers include adding a legal monopoly to a natural one and the ability of the franchising authority to extract payments from the franchisee at considerable social costs. Posner attributed the fact that municipalities grant cable franchises on an exclusive basis not to any inherent characteristics of cable television, but ". . . because they seek a share of the monopoly profits in the form of franchise fees".5 The idea that cities share in the monopoly profits of their cable operators and that this 7'RichardA. Posner, "The appropriate scope of regulation in the cable television industry," ae11_legznel_e£_fieenemlee and_uanegement_fieienee 3:1. Spring 1972. 115. 3 Ibid., 113. represe number I Ir of Phil' charact is know To Webb 46 represents a misallocation of resources is a concern of a number of researchers. In a case study of the franchising process in the City of Philadelphia, Webb discovered that the process was characterized by political infighting and typified by what is known as "rent-a-citizen" and ”rent-an-institution”.° To Webb, The dynamic that united both the grantors and grantees of municipal cable franchises was that the process would pay dividends to both sides. In the pro forma arrangement, a city would auction off the franchise to the cable firm bidding not the highest dollar amount to the municipal treasury, but the most compelling set of political payments, favors or subsidies.° The city went through four competitive bidding stages; the first in 1966, the fourth in 1982. When Webb published the results of his study in 1983, most of Philadelphia remained uncabled. He concluded that while competitive bidding for a cable franchise results in the proposal of prices that can be expected to produce approximately normal returns for the firm. . . 9 The term "rent-a-citizen" is used to refer to the practice of a cable applicant giving an individual with locally important political ties stock in the firm in exchange for their support. The term "rent-an-institution” is used when the arrangement is done on an institutional basis. In his study, Webb gave the example of a joint venture that would have given the University of Pennsylvania a low-interest loan to purchase a 20 percent share in the proposed cable system in exchange for the use of the university's name and some office facilities. ‘° G. Kent Webb. MW. (Lexington: Lexington Books, 1983), 180. franch' Nadel resouré evaluat these 5 T) by Web} conces biddin ZUpan additi T) rf run: pu-rrna.r+r—~ Franchi 1983, 5 ldenc' 47 monopoly power has not been eliminated, it is instead exercised directly by the municipality which may require extensive investment in public facilities as one of the terms of the franchise contract.11 In discussing the difficulties associated with the franchising procedure as it is conducted in most places, Nadel noted that the process forces applicants to allocate resources to public service offerings "without any evaluation of whether the benefits derived from offering these services justify the costs."12 The public service offerings and facilities mentioned by Webb and Nadel represent what are known as nonprice concessions and are one of the factors that make franchise bidding an imperfect solution to a natural monopoly problem. Zupan used Demsetz as a starting point and outlined additional factors which make franchise bidding problematic. [In Demsetz's model,] ex ante competition is relied on to ensure that, ex post, the winner of the competition does not behave monopolistically. But in reality, there may be imperfect competition at the time of initial bidding, producer "capture" of the regulatory process, . . . and difficulties in enforcing a franchise contract once it is struck --especially if the incumbent firm has distinct advantages over potential rivals and is prone to opportunism.13 " Ibid., 179. ‘2 Mark S. Nadel, "COMCAR: A Marketplace Cable Television Franchise structure." WW 20: 541. 1933, 547. ‘3 Mark A. Zupan, "The Efficacy of Franchise Bidding Schemes in the Case of Cable Television: Some Systematic Evidence." TheIIeurnal_ef_Law_and_Eeenemies 32: October 1989. Although surface most 81: tranchi free ho network as a pe would a the co: Signif the ex Often 3&2191 the q; Sdher tact Onst Com 11 J 401 48 Although all of the conditions detailed by Zupan frequently surface in the cable television franchising process, the most significant may be the nonprice concessions that franchisors require. These may include direct endowments, free hook-ups for public institutions, institutional networks, excess channel capacity, and franchise fees levied as a percentage of operating revenues. To this Hazlett would add the costs of delays in awarding the franchise and the costs of political lobbying. These concessions are significant because it is believed that they are achieved at the expense of lower prices for general services and are often of little value to the ultimate consumer. Zupan and Hazlett would argue that this represents a curtailment of the efficiency enhancing potential of franchise bidding schemes.“ To test the hypothesis that nonprice concessions are in fact costly, Zupan surveyed managers of cable systems coming onstream during the early 19808. He found that "nonprice concessions accounted for 26 percent of building costs and 11 percent of operating expenses."15 And, 401 and 402. “ Zupan, 404. Hazlett, "Private Monopoly and the Public Interest: An Economic Analysis of the Cable Television Franchise,” 1409. ” Zupan, op. cit., 417. firn fran reve have was its POWe foun 49 of the expenditures related to nonprice concessions, a sizeable portion appeared to provide only limited economic benefits. Institutional networks, for example, accounted for 14 percent of construction costs but generally lie idle.“ Zupan's results are similar to those of the accounting firm, Ernst and Whinney. It found that for a typical franchise, approximately 22 percent of total subscriber revenues were used to cover costs which the system would not have incurred without the franchise requirements."7 Despite its flaws, both Zupan and Webb found that there was some merit to the franchising bidding process. That is, its ability to prevent monopoly pricing and transfer market power from private firms to municipalities. Even so, Webb found it ironic that although much of the public concern regarding the abuse of monopoly market power has been directed at the private firm, it is often the municipalities charged with regulating the industry that have wielded the market power.18 Phillip A. Beutel questioned whether cities do in fact use their market power to select a cable operator on the basis of factors that would be inconsistent with the preferences of the average consumer. Using data from contract bids for 27 randomly selected municipal auctions '6 Ibid. ‘7 Hazlett, "Private Monopoly and the Public Interest: An Economic Analysis of the Cable Television Franchise,” 1363. ‘m Webb, op. cit., 180. 50 that took place across the United States between 1979 and 1981, Beutel found that cities selected firms with local or regional advantages and preferred relatively fewer unprofitable services and relatively higher basic tier prices. Beutel cited the cities' desire to transfer rents in kind to special interest groups or in cash as a source of revenue to bolster municipal tax coffers as a possible reason for selecting firms with the higher basic prices. The finding that cities choose firms with relatively fewer unprofitable services seems to conflict with the findings of Zupan and Webb. But, Beutel reasons that this ”merely reveals bidding firms' overestimation of the impact of special interests over local authorities"19 Alternately, Beutel suggests that cities recognize that nonprice concessions are costly and reduce a firm's profits, thereby reducing the cities' revenue. Overall he concludes, ”the results suggest that monopoly franchising may serve private interests at the average consumer's expense.“20 This appears to verify the conclusions drawn by Webb, Zupan and Hazlett. ‘w Phillip A. Beutel, "City objectives in. monopoly franchising: the case of cable television," W 22: 1990, 1245. In his study, Beutel used the same data as Owen and Greenhalgh did in their study of competitive issues in cable television franchising. 2° Ibid. , 1237. it ar a] pe be pr CC T11 1e 19 \ 51 In their studies Zupan and Webb used pre-1986 data. ‘While the Cable Act of 1984 effectively deregulated rates, it permits a franchise authority to continue to require that an operator provide nonprice concessions. The Act also allows the authority to charge an operator up to five percent of gross revenues as a franchise fee. In part because cities are no longer able to prevent monopoly pricing but continue to require costly nonprice concessions, «consumers have been saddled with increasingly higher rates. 'This suggests that the franchising bidding process may be jless meritorious than it was prior to the passage of the 1984 Act. Hazlett has written, franchising without rate controls essentially involves just the transfer of rents. This actually promotes inefficiency because these redistributions are not enacted via direct money payments to individual decisionmakers, but are paid through public organizations via the political process. The deregulated franchise monopoly then promotes wasteful rent seeking, substitutes political selection for consumer selection of the monopolist or duopolist and freezes out new forms of technology and innovative organizations or delivery modes, while failing to offer even a plausible chance of welfare gains through price controls or rate-of-return regulation.21 To Zupan, Webb and Hazlett, the key drawback to the franchise bidding process is that it results in the v Thomas W. Hazlett, ”Duopolistic Competition in Cable Television: Implications for Public Policy," W 7:65 1990, 85 and 86. 52 inefficient transferral of economic rents from monopolists to municipalities rather than to consumers. And, to Webb, one severe limitation to the bidding process, is the fact that once the franchise has been awarded and a cable operator is established as an incumbent, direct competition is all but removed from the market. One solution to the problem of franchise bidding in cable would be to adopt a policy of open entry. Hazlett is one of the chief proponents of this type of policy. He sees the fact that it would offer maximum consumer surplus, while leaving zero surplus for politicians to extract, as its key justificationd22 To support his proposal, Hazlett refers to a NTIA study which concluded that the common occurrence of exclusive cable franchises does not serve the public interest. The franchising process has seriously impeded entry by competitors and imposes substantial costs on franchisees, cable subscribers and the public.23 As might be expected, a policy of open entry has its critics. Because control of entry is one of the key ways that franchising authorities use to transfer wealth, the majority of municipalities continue to grant exclusive :a Thomas W. Hazlett, "Private Contracting versus Public Regulation as a Solution to the Natural Monopoly Problem,” in Unneggreleuenepelieee Robert W. Poole, Jr., ed., (Lexington: Lexington Books, 1985), 84. 23 Thomas W. Hazlett, "Should Telephone Companies Provide Cable TV?" Begylegien Winter 1990, 73. fr he th a1 ar 10 CO fr di "t2 ca; th.‘ 53 franchises. This may certainly change under the 1992 Cable Act but, as late as 1989, Hazlett wrote that the National League of Cities "has vigorously fought open-entry claims in the courts and has consistently advised its members against allowing competition in cable."“; genegmere;_3eeeezen has argued that one of the reasons for this is cities' fear of lost revenue if there is more than one operator. And while conceding that the transferral of rents that occur under franchise bidding schemes may not be desirable from a distribution perspective, Albert K. Smiley argues that "they should not be counted as welfare losses since they are captured by the recipients."25 And, even if monopolists do transfer rents to public officials, it is unclear what portion of the monopolist's incremental profits is dissipated in inefficient rent-seeking activities and what portion is transferred to franchise authorities and special interest groups . 2‘ Smiley identifies cream skimming and the possibility that in some markets, a welfare maximizing natural monopoly 2" Hazlett, "Cabling America: Economic Forces in a Political World," 220. 25 Albert R. Smiley, "Regulation and Competition in Cable Television," response to Hazlett in WW1) 7:121 1990, 127. 2‘ Ibid. Te Te 54 may be unsustainable without regulations prohibiting entry as a potential problem of an open entry policy.”' If selective entry (cream skimming) persists, the natural monopolist will eventually exit or not enter at all and the loss of consumer surplus in the low- density neighborhoods may exceed the gains in the high density neighborhoods. If open entry results in a net reduction in total welfare and consumer surplus, a strong case can be made for franchise protection.”3 But, to Hazlett the notion that [without a monopoly franchise] service will be denied some areas is testimony that either the cost of providing the service is greater than it is valued by the consumers, or that customers must be charged identical prices. The fact that municipal cable franchises routinely stipulate fixed community- wide prices as well as universal service . . . is clearly economically inefficient . 29 Hazlett argues further that consumer surplus must rise as entry takes place because of reduced prices and expanded output to consumers. To Hazlett, the primary advantage of open market selection is that it spontaneously distributes rewards in the form of profits to those entrepreneurs who most efficiently meet consumers' preferences for diversity. "The political selection of product or service . . . cannot 27 The term cream skimming is used to refer to the practice of selectively entering only the more lucrative segments of a market. 2° Smiley, "Regulation and Competition in Cable Television," 130. 2’ Hazlett, "The Policy of Exclusive Franchising in Cable Television," 14. 55 match the vastly more efficient selection that takes place in the open marketplace.“so Since the primary purpose of a cable television franchise is to give operators legal access to public rights-of-way, it would seem that there should be a middle ground between the two extremes of exclusive franchises and completely unrestricted entry. That middle ground would be a policy of nonexclusive franchises whereby competition between operators would be encouraged while cities would maintain some control over the public domain. Successful court challenges such as Exefiezzeg to exclusive franchise policies, the inclusion of a provision that "(1) prohibits franchise authorities from unreasonably refusing to award additional franchises" in the final version of The Cable Television Consumer Protection and Competition Act of 1992 n and a finding by the National Association of Telecommunication Officers and Advisors (NATOA), an arm of the National League of Cities, that 90 percent of 3° Hazlett, "Private Monopoly and the Public Interest: An Economic Analysis of the Cable Television Franchise," 1383. 1“ Congress, Senate, committee on Commerce, Science and Transportation, e s o 8 er P 1221, report of the Senate Committee on Commerce, Science and Transportation, Together with Minority Views on S. 12, lolst Cong., 2d 8883., 1991, GPO 1991, 14. The provision.cited.in.the text above was included in the final version of the Act as passed by both houses of Congress in October, 1992. 56 municipalities responding do not bar competition between cable operators32 provide evidence that support for this type of policy is gaining momentum. But, even the most strident supporters of direct, head- to-head competition between cable operators state that the extent to which this type of competition is feasible is determined in large measure by a combination of market factors and political conditions. And, that competition is 3” One of the factors probably not feasible in all markets. that impact competition is the strategic interaction between firms. This behavior is the subject of the following chapter. 32 Thomas Cohan and William F. Squadron, "NATOA Survey Finds Soaring Cable Rates," W, April 29, 1991, 1. The survey cited. was completed. by 184 local cable regulators who are responsible for 1,002 franchises. This represents about ten percent of all systems in the United States. Since there was no mention of how the sample was chosen or what the overall response rate was, the results of the survey may be biased towards cities with more liberal entry policies and may not reflect the policies of most municipalities. 33 Rush Rice, President of Montgomery, Alabama CableVision, interview by author, Lansing, Michigan, August 31, 1992. Cushing interview. Both companies operate cable systems which compete with an established operator. Ci R1 Ci t: b: '11 D.» t) D1 \ H1 CHAPTER VI STRATEGIC BEHAVIOR In cases where two cable operators compete with one another, the market can be described as a duopoly, a special case of oligopoly. Robert S. Pindyck and Daniel L. Rubinfeld have stated, "in oligopolies, each firm must carefully consider how its actions will affect its rivals and how its rivals are likely to react."1 In his simulation of direct competition between cable television systems, Smiley found that the degree of overbuilding as ‘well as the resulting welfare effects are highly sensitive ‘to market factors including the strategic interaction Ibetween firms. fIn oligopolistic situations, that strategic r#.”’ I {intéiaééiéfi involves competition through price setting f and/or product differentiation. ”.Emige_§e§ting The Betrand model describes the type of competition 'that occurs in cable television. This model assumes that firms produce a homogenous good but compete by setting jprices, with each firm taking the prices of its competitors \ ‘ Robert S. Pindyck and Daniel L. Rubinfeld, nigrgeeenemiee, (New York: Macmillan Publishing Company, 1989), 427. 57 as the unc doe te] the eqr dei pri tn it occ and Car. IEC For any Pin the Tel 58 as fixed and the firm with the lowest price capturing all the sales. In this case, each firm has an incentive to undercut the price of its competitor until price is driven down to marginal cost.2 Smiley noted that when considering entry into a cable television market, a potential entrant should anticipate that the incumbent's price will be reduced in the post-entry equilibrium to meet the competitive challenge.3 Sharkey defines this type of strategy as one which "explicitly uses price as a threat against potential rivals."‘ With this type of strategy, the incumbent firm "clearly indicates that it is willing to lower its price temporarily if entry should occur and thereby inflict short-run losses on both itself and on the entrant. After the rival has left, the incumbent can then raise its price to the monopoly level and therefore recover its short-run losses."5 The key purpose of this strategy is to deter entry. For it to be successful, the incumbent firm must convince any potential competitor that entry will be unprofitable. iPindyck and Rubinfeld state that there are a number of ways ‘that an incumbent can do this. For instance, it can \ 2 Pindyck and Rubinfeld, 433, note 3. 3 Smiley, "Regulation and Competition in Cable Television," 132. ‘ Sharkey, op. cit., 146. 5 Ibid. {'1 t1 Ir 59 threaten to expand output and fight a price war to keep the entrant out. To make the threat credible, the incumbent can make an irrevocable commitment that would alter its incentives once entry has occurred. Investing now rather than later in the extra capacity needed to increase output is an example of this type of commitment. The incumbent can also make its threat credible if it has a reputation for irrationality. If through vicious price-cutting, the firm has driven out every competitor in the past, even though it incurred losses to do so, its threat of a price war would be believable. In fact, if this were repeated in several ‘markets, then that irrationality would become rational. The reason is that short-term losses from the price warfare :might be outweighed by longer-term gains from preventing entry.6 Hazlett found evidence of price cutting in his case studies of direct competition in cable in several Florida :markets and in Sacramento, California. "In Florida, the response of the overbuilt incumbent to entry by Telesat was ‘to reduce the prices of both pay and basic services although only in overbuilt areas."7 In Sacramento, the entrant, Cable America hoped to gain market penetration by offering 36 to 42 channels of basic service for a $10 installation fee and $10 per month. This significantly undercut the incumbent, 6 Pindyck and Rubinfeld, op. cit., 478 and 479. 7 Hazlett, "Duopolistic Competition in Cable Television: Implications for Public Policy," 101. DC Cd V8 be 0f CO in re: to Th: 60 Scripps-Howard's 40 channel basic service which was offered for $14.50 per month. In response, Scripps- Howard sought to establish a general policy: it would lower its price for basic service while offering free installation and three months of basic service at no charge in every area where it faced direct competition. Moreover, it pledged never to be undersold by the entrant. After a rugged six months of competition, Scripps-Howard bought out Cable America for a price several times the incumbent's capital costs. A third firm entered the market and was immediately confronted by Scripps-Howard's selective price-cutting strategy. The new entrant, Pacific West decided to make an issue of the discriminatory strategy through newspaper and radio advertisements suggesting that customers in sole- supplier areas demand the same low prices offered by Scripps-Howard in overbuilt areas.8 geneemeze;_3eeee;eh also found evidence of selective price-cutting. In a study of competitive versus noncompetitive markets, it found that while the price of cable was lower to subscribers in areas with competition, it ‘was higher in directly adjacent areas without competition.’ While price wars certainly occur, whether they are Jbeneficial to society is open to debate. From their study of multiple versus single cable systems, Johnson and Blau concluded that while there may be short-term benefits to jprice war, for example, lower prices and improved services, in the long run, competition will be eliminated with the remaining operator raising prices and/or decreasing service 10 to make up the losses incurred during the price war. This implies that there are no consumer benefits to be 3 Ibid., 104. 9 Merline, et. al., op. cit, 11. w Johnson and Blau, op. cit. Te di SE be "A Ch Co Te; 61 derived from a price war. Hazlett, Posner, and others disagree. Hazlett believes that a price war, even a temporary one is better for consumers than none at all and that it will not prohibit entry altogether. "The temporary price war is considered a gain to consumers and the loss seen as the investors' appropriate penalty for mistaking market conditions in the pursuit of profit."11 Posner believes that even under natural monopoly conditions the public is better served by allowing natural economic forces to determine business conduct and performance, subject only to the constraints of antitrust policy.12 In testifying as part of congressional oversight hearings on cable, Eddy Patterson, Mayor of Henderson, Tennessee provided evidence that consumers do benefit from direct competition in cable television delivery even though a price war may occur. Patterson stated that as soon as the second cable franchisee began installing its customers' hookups in Henderson, the incumbent began cutting its rates. "All of a sudden, Henderson, Tennessee is enjoying the cheapest cable rates probably in America today. . . Competition was the only thing that has brought about more " Hazlett, "The Policy of Exclusive Franchising in Cable Television," 12. n Posner, "Natural Monopoly and Its Regulation," 580. Irv 62 programming and a reduction in basic cable rates here in Henderson."13 W A second type of competitive strategy in oligopolistic markets is product differentiation. In his discussion of competition in electric utilities, Primeaux stated that the notion that a small price difference between competitors would lead buyers to purchase from the producer charging the lower price assumes that the product is homogeneous.“ However, this assumption "ignores entirely the possibility that product differentiation is possible and that other reasons such as good service and company reputation may also exist which discourage an individual from switching to a lower priced producer."1s F. M. Scherer has stated that product differentiation includes service, physical differences in the products supplied and the subjective images they impress on the consumer's mind.16 Pindyck and Rubinfeld have noted that "product differentiation can exist even for a seemingly homogeneous product." In this case, ‘3 Congress, Senate, Committee on Commerce, Science and Transportation, mersight of gable Televisien: Heeringe 9' 0 ‘ 9‘ 011-1!tee 0! “rue ‘ .n- 2150011 .91, "Statement of Eddy Patterson, Mayor, City of Henderson, 'Tennessee," lolst Cong., lst sess., November 16 and 17, 1989, 219 and 221. “ Primeaux, "Some Problems with Natural Monopoly," 80. " Ibid. “ F- M- Scherer. WWW Perfezmeneee (Chicago: Rand McNally and Co.), 1970. 63 "differentiation will be on the basis of such things as location and services."17 With respect to cable television delivery, product differentiation is likely to be done on the basis of service. Service includes attitudes of customer service representatives both on the telephone and in person, response to customer complaints, and the convenience of installation. Smiley argued that product differentiation is not likely to be done on the basis of program offerings because consumers would probably prefer to have the entire menu of programming options available on one system.18 That being the case, it is critical that entrants as well as incumbents have access to the programming services that consumers find attractive. Congress recognized this and adopted provisions which prohibit most exclusive programming contracts as part of the Cable Act of 1992.19 However, there may eeme differentiation in terms of program offerings, particularly if the competing systems have different channel capacities. Additionally, a system :may choose to distinguish itself from its competition by providing locally-originated programming. '" Pindyck and Rubinfeld, op. cit., 433, note 3. ‘3 Smiley, "Regulation and Competition in Cable Television," 132 and 133. ‘9 Cable Act of 1992, Section 628. IF: be F] at we IS th ma th 64 W In addition to being a competitive strategy, product differentiation also affects the viability of price cutting. That viability is also affected by long-run barriers to entry. As was discussed at length in the chapter on franchise policy, franchise requirements are one of the key entry barriers that exist in cable television delivery. From his Florida and Sacramento studies, Hazlett learned that in addition to selective price-cutting by incumbents, entrants were also confronted with a negative political climate. In 1987 The Florida Cable Television Association won passage of a statute which requires all new entrants to gain cable franchises and establishes strict standards and extensive procedures for their issuance. Requirements include a lengthy series of mandated public hearings and studies to establish whether any public need exists for a cable entrant and to insure that, if public need does exist, the second franchisee receives permission to enter on terms no less onerous than those included in the incumbent's franchise award.20 The fact that the statute was passed at the behest of the Florida Cable Television Association suggests that it :may be at least partly protectionist and not necessarily in the public interest. 2° Hazlett, "Duopolistic Competition in Cable Television: Implications for Public Policy," 101 and 102. 65 In Sacramento, the city was ordered by the court to issue a franchise to the entrant.21 However, Hazlett found that in adopting its "so-called open entry policy" the city's cable commission did not give up its natural monopoly defense of franchising. "It issued entry licenses with a five-year life only and publicly maintained that competition would not develop and endure in the marketplace. "22 As noted earlier, as of late 1990, Pacific West Cable was providing cable service in portions of Sacramento in competition with Scripps-Howard. In 1988 four states passed laws that to varying degrees restrict overbuilds. According to uglgienenne1_flege, in Minnesota "the so-called fairness statute would not bar two or more operators but would compel overbuilders to be subject to the same requirements as incumbent operators. . . Cities are also free to require more stringent provisions in other terms of the second system's franchise."3’ Illinois, Tennessee and Oklahoma adopted statutes similar to that enacted in Minnesota. Additionally, in the latter two states, the laws include provisions designed to thwart entry a .1 op. cit. t... ‘ 'UP'! . ‘ .o. t!!'! ' 22 Hazlett, "Duopolistic Competition in Cable Television: Implications for Public Policy," 103. In footnote 140 Hazlett states "the commission issued a 20 year franchise to the original cable operator and extended that franchise for an additional 20 years." ‘3 Linda Haugsted, "Ops Won Overbuild Protection in Four States," Mnltichannel.flews. December 26. 1988. 8. 66 by utilities.“’ Whether these statutes will be nullified by the 1992 Cable Act is a question that will be resolved over time. In all four cases, the laws were drafted at least in part by state cable television associations and were supported by the cities. The incumbent operators seek this type of legislation to ensure that entrants are not given preferential treatment and because overbuilds result in lower penetration rates and higher marketing costs. It has been suggested that cities like Sacramento take the positions they do because they fear that competition will result in a decrease in the franchise fees received from cable. Another possibility is the reluctance of the cities to lose the rents that are transferred to them under monopolistic situations. While some of the requirements contained in the statutes outlined above would ensure that entrants and incumbents are treated equally and fairly, others such as the series of public hearings and studies mandated by the Florida law may serve no other purpose than to delay entry. Another tactic frequently used by incumbents to delay entry by a rival is to engage in litigation. While serious issues such as antitrust violations may be addressed in that litigation, at times the suits are rather frivolous and concern such things as the ownership of the internal wiring in subscribers' residences. 2" Ibid., 8 and 34. 67 In addition to the strategic interactions between firms and long-run barriers to entry, the success of an overbuild is highly sensitive to market conditions. These conditions and the method used in this dissertation to study competition in cable television delivery is detailed in the following chapter. CHAPTER VII METHOD Smiley stated that the degree of overbuilding in cable television is highly sensitive to such factors as the intensity of demand, the ability of the entrant to differentiate its product from that of the incumbent and the cost of cabling the community. Others have noted that population density is a critical factor in determining whether competition is feasible. A study commissioned by Times Mirror Cable Television and conducted by Malarkey Taylor Associates found that "there must be about 110 homes per mile or about 90 homes per mile with very poor reception of broadcast stations off-air" in order for two cable operators to make a profit in a complete overbuild situation.‘ Rush Rice, of Montgomery CableVision concurred with the findings of Malarkey Taylor and added upside potential in penetration and low off-air station counts as additional factors supporting competition.2 ' J. L. Freeman, "Study Finds Profits Elusive When Two Systems Overbuild," Mgleienenne1_Nege, April 13, 1987, 17. 2 Fred Dawson, "Cable Not a Natural Monopoly, But a Tough One." W. New 8. 1992. 13- 68 ch CC 69 One would expect to find at least some of the following characteristics in a market with direct head-to-head competition between cable operators: 1 l.) a high demand for cable 5 2.) a population density of at least 90 homes per mile { 3.) less than a full complement of over-the-air j broadcast television stations and/or the presence of a uhf broadcast stations j 4.) terrain that makes over the air reception of i television signals difficult a 5.) higher than average cable penetration 6.) opportunities to increase penetration by ; successfully marketing both former subscribers and 1 those who have never had cable ‘ 7.) lower than average costs of cabling the community 8.) lower than average median household incomes3 One would also expect to find evidence of dissatis- faction with the incumbent operator in markets with head-to- head competition. For competitive entry to occur, the incumbent's franchise must be nonexclusive and there should be evidence that the franchising body is truly receptive to competition. If a city had been involved in litigation because it refused to grant a second franchise despite a stated policy of non- exclusive franchising, one would not consider such a municipality a friend of competition. Based on Smiley's findings and Hazlett's studies of overbuilding in Florida and California, the potential 3 While this appears counterintuitive, Primeaux found that cities with lower than average median household incomes were likely to be supportive of competition. This is due to the fact that households with lower than average median incomes are thought to be more price sensitive than higher income households. 7O entrant should anticipate that the incumbent will reduce its price in the overbuilt areas in an effort to thwart competition. This is likely to lead to a price war, 2:”. least in the short run. The duration of the price war will ‘m. ND...— 1 F“.Ww.w'_ .“‘ depend in part on the ability of the incumbent to run at a lossflend the ability of the entrant to withstand the price war and differentiate its product from that of its rival.i Montgomery, Alabama and Paragould, Arkansas are two examples of cities where direct competition between cable operators occurs. Through case studies of these two markets this dissertation determines which of the market conditions that the literature suggests impact competition occur in these situations. The study also identifies which of these conditions are the most critical to successful entry and outlines additional factors that affect the feasibility of competition in cable television delivery. Second, the case studies consider the political climate in Montgomery and Paragould as it relates to entry by a second cable operator. Third, the studies examine the behavior of the incumbent in response to entry by a rival. For example, the studies assess whether the incumbent engaged in price cutting, entered into litigation in an effort to prevent entry and/or attempted to subject the entrant to franchise requirements that are at least as stringent as those under which it operates. The studies also address how the entrant has reacted, on what dimensions 71 competition has occurred, and whether this competition has resulted in improved service and/or lower prices for subscribers. Fourth, the studies determine the extent to which these overbuilds have been successful, and assess the likelihood of their continuing operation. One of the objectives of the dissertation was to gain information that can be applied to other markets and used to affect public policy. As discussed in Chapter I, the case study method was selected because it enables the researcher to take an in- depth approach to complex issues and, direct competition in cable television delivery is certainly a complex issue. To identify cases for study, several techniques were used. First, a list of markets with overbuilds compiled by the research firm, Paul Kagan Associates, Inc. was crossreferenced to the 122l_Ieleyieien_geb1e_§eegbeeke The Kagan list had 65 cases of duplicative franchises. Of these, 15 had only one operator listed in the Eeegbeeke Four more areas were subdivided into smaller areas with one operator each. Five were crossreferenced to other areas with one operator each, and three were not listed. Thirty eight cases remained.‘ Of the remaining cases four are municipal overbuilds and were considered separately. The ‘ See Appendix B for the complete list of 65 cases. Montgomery is a recent overbuild and was too new to be included in either the Kagan list or the Factbook. 72 1990 Cenenmere;_3eeeeren study provided an additional check on the list of overbuilds. Both scholarly and trade journal articles were used to identify individuals who were involved in overbuilding. The Executive Director of the Competitive Cable Association was contacted as a potential source for previously unidentified cases and to obtain suggestions on cases to study. Among the persons identified through these sources was Harry P. Cushing, III, the President and Chief Executive Officer of Telesat, the nation's largest overbuilder and Rush Rice, President of Montgomery CableVision and Entertainment, Inc. Both were interviewed via telephone in late August/early September, 1992 and provided insight on the issues related to competitive cable. Because the Telesat systems were studied in-depth by Hazlett the decision was made to study others.s Montgomery, Alabama was selected for study for several reasons. First, it is an example of an independent operator competing with an established multiple system operator. Montgomery CableVision, the new entrant, is the cable arm of a locally-owned investment banking firm. Some of the company's stockholders also have an ownership interest in the Troy, Alabama system which is a successful overbuild. 5 Additionally. according to W. Time Warner, Inc. agreed to buy out the Telesat systems in central Florida in December, 1992. ”Florida Rival Bought Out". W. December 10, 1992, A10. 73 The incumbent, Storer/TCI is owned by the largest multiple system operator in the country, Tale-Communications, Inc. Montgomery CableVision was granted a franchise in January, 1990 and began construction shortly thereafter. The system is approximately 20 percent complete. Second, Montgomery is a reasonably sized city within a distinct television market. Montgomery/Selma is the 105th largest market according to both Nielsen and Arbitron. Third, the city has a favorable policy towards competition in cable. It passed two ordinances designed to foster that competition. One ordinance prohibits program exclusivity in restraint of free trade and the other requires any operator who lowers cable rates in one geographic area to do so in all areas of the franchise. Fourth, Montgomery CableVision joined the city of Montgomery in litigation with Turner Network Television (TNT), ESPN and Storer/TCI over the rights to the cable networks' programming. Preliminary findings suggested that the situation in Montgomery is somewhat typical of those where an independent operator competes with a large multiple system operator. The entrant asserted that the incumbent, Storer/TCI, uses its market power, particularly with respect to programming, and its ability to engage in price cutting and litigation as part of its competitive strategy. It is unlikely that one would see this type of behavior in a market where two 74 relatively small independent operators competed with each other. Municipal overbuilds present a set of issues that are distinct from those related to situations where one private operator competes with another. Brenner and Price have stated "Nothing in the 1984 (Cable) Act forbids municipal ownership of cable service"6 and the 1992 Act specifically permits city overbuilds.7 Brenner and Price also stated that city ownership can raise antitrust liability especially where a city-owned system competes with a privately-owned system outside city limits. In hearings before a U.S. Senate Subcommittee, Richard Berman, a communications attorney and former general counsel, executive vice president and director of Warner Cable testified that "municipal overbuilds waste taxpayers' money and move government into a realm where it doesn't belong, namely editorial control."8 Municipal ownership of a cable system has its pros and cons. On the pro side are arguments that municipal ownership aids the overall economic development of a city ‘ Brenner and Price, op. cit., 5-53 Section 3.06 [4][c]. 7 Cable Act of 1992, Section 621. ’ Congress, Senate, Subcommittee on Antitrust, Monopolies and Business Rights of the Committee on the Judiciary, °!" ° iv- ssues 9‘ .9 - — evisi-n nous g.’ .-- ,1-; 32° ‘ {LueSbCO' t“ 0111A ' M'!‘.°° ‘_ :10. =__- 1’=-‘ Bishts_2f_the_Q2mmittee.en.the.£ndiciarx. 100th Cong-. 2nd sess., March 17, 1988, 158. 75 through the delivery of services and assistance via cable and results in lower subscriber rates, new sources of jobs and revenues and a better quality of service.9 'The downside of public ownership comes from problems in obtaining financing, a city's lack of expertise in operating a cable system, potential conflicts of interest, restraint of trade and the possible politicization of programming and access allocation.1o In addition to the four municipal overbuilds included in the list compiled by Paul Kagan Associates, Inc. three more were identified.11 Of these, Paragould, Arkansas is perhaps the most successful. The city began operation of its system in March, 1991 in competition with Cablevision Systems, a large multiple system operator. The city's system is 100 percent complete. There are about 3200 subscribers, about 50 percent of the total number of cable customers in Paragould. Prior to beginning construction, the city successfully litigated its case in the federal and 9 Jean Rice, "Public Ownership Models," in W CTIC Cablebooks Volume II, Nancy Jesuale ed., (Arlington, Virginia: Cable Television Information Center, 1982). Eli M. Noam, "Towards an Integrated Communications Market: Overcoming the Local Monopoly of Cable Television," WW 34: 2. 209- 257- 10 Ibid. Michael J. Henderson, "Municipal Ownership of Cable Television: Some Issues and Problems" gemmLEnL_Leg_leg;nel 3:4 667-683. " These are.Niceville, Florida, Paragould, Arkansas, and Elbow Lake, Minnesota. 76 state courts. As noted in Chapter I, the history of the Paragould case and the current status of the overbuild illustrates the type of behavior in which an incumbent engages to thwart competitive entry, particularly by a municipality and the legal conditions under which a city can provide cable television service in competition with a private operator. This is especially relevant in light of the passage of the 1992 Cable Act. Similar approaches were used to study both Montgomery and Paragould. In Montgomery, personal interviews were conducted in February, 1993 with representatives of both the incumbent operator and the overbuilder. The entrant was asked specifically why it chose Montgomery as a market to overbuild and the steps it took to ensure that entry would be achieved. To assess demand and other market factors, feasibility studies conducted by the entrant were examined. Questions pertaining to the strategies it uses to compete were also be posed. The incumbent was asked how it has reacted to the overbuilder, particularly from a price/service perspective. Interviews were also conducted with representatives of city government to ascertain why the decision was made to allow a second cable operator to construct a system in Montgomery. Press releases, newspaper reports, city council meeting minutes and resolutions, cable ordinances, franchise agreements, and other public documents were reviewed to 77 obtain information on the history of cable franchising and service in Montgomery. Correspondence between various parties provided additional information on the competitive situation in Montgomery. The entrant was forthcoming with financial information, making it possible to assess the system's performance vis a vis the average U.S. cable system. The incumbent provided summary information on the franchise fees it paid to the City of Montgomery, allowing the researcher to extrapolate the system's overall subscriber revenues and compare its performance to the industry average. Both companies also supplied information on their pay-to—basic ratios, again making it possible to draw comparisons between these systems and the industry average. Because the City of Paragould was involved in a series of suits with the incumbent, Cablevision Systems, court proceedings were used to identify some of the legal issues that are unique to situations where a municipality attempts to overbuild a private operator. As in Montgomery, personal interviews were conducted in February, 1993 with representatives of both cable systems. City officials were asked specifically why they decided to overbuild an established operator. Questions relating to competitive strategy were also posed to both operators. Press releases, newspaper reports, city council meeting minutes and resolutions, cable ordinances and franchise agreements and 78 correspondence between parties were reviewed to obtain information on the history of cable franchising and service in Paragould. Because the city's system is owned by the people of Paragould, financial data was available that was used to assess the system's performance vis a vis the average U.S. cable system. In Paragould, information was also available on the franchise fees paid by the incumbent, making it possible to extrapolate that system's overall subscriber revenues and compare its performance to the industry average. As was the case in Montgomery, both companies also supplied information on their pay-to-basic ratios, again making it possible to draw comparisons between these systems and the industry average. The primary objective of these studies was to answer the research questions outlined in Chapter I. It was expected that by answering these questions a picture of what direct competition in cable television delivery looks like would emerge. It was also expected that the results of these studies would have implications for public policy. Finally, the results have been used to develop an agenda for further research. Chapter VIII MONTGOMERY WW Montgomery, the capital of Alabama, has several of the market characteristics one would expect to find in a city with two competing cable companies. First, there is a high demand for cable and cable penetration in Montgomery is .... higher than the national average. Although the terrain is a. flat, about 72 percent of the homes passed subscribe to cable.1 Second, the city has an average population density of about 100 homes per mile.2 Third, although Montgomery is served by five commercial and one public broadcast television stations, only two of the stations are VHF.3 ‘ Gilbert, interview. The average cable penetration in the United States as of 1992 is approximately 62 percent of homes passed. Paul Kagan Associates, Inc., August 31,1992 reported in NW. National Cable Television Association, October 1992,1-a. 2 William B. (Bill) Blount, Chairman and Rush Rice, President, Montgomery CableVision and Entertainment, Inc., interview by author, tape recording, Montgomery, Alabama, February 22, 1993. 3. Montgomery is served. by the following’ broadcast television stations: WHOA, Channel 32 (ABC): WAKA, Channel 8 (CBS): WSFA, Channel 12 (NBC): WCOV, Channel 20 (FOX), WAIQ, Channel 26 (PBS): and WMCF, Channel 45 (Independent/Religious). 79 Fourth, the cost of cabling Montgomery is low relative to other parts of the country. Approximately 85 percent of the system is aerial at a cost of $15,000 per mile including make ready, while 15 percent is underground at a cost of $23,000 to $24,000 per mile.‘ .Additionally construction costs in Montgomery are low, with labor running about 40 cents per foot, aerial.5 Fifth, the average median household income in Montgomery in 1989 was $26,311 almost $5,000 lower than the national average of $30,056.6 Belitical.£actor§ Although many of the market characteristics one would expect to find in a city with competing cable companies are present in Montgomery, it appears that it was the favorable political climate that more strongly influenced the entrant's decision to compete. Montgomery CableVision and Entertainment, Inc. (Montgomery CableVision) was incorporated by William B. Blount, a principal in the investment banking firm of ‘ Rice interview. 5 Ibid. Rice compared Montgomery CableVision ' 8 construction costs to those incurred by Telesat in its attempt to overbuild various multiple system operators in central Florida. Because of zoning and environmental standards, Telesat was forced to build all of its systems underground at a cost of approximately $30,000 per mile. On average, it costs $12,000 per mile aerial and $20,000 per'mile underground to construct a cable system.in the United States. 6 Summary Social, Economic and Housing Characteristics, U.S., November 1992. 80 81 Blount, Parrish and Roton, on December 29, 1989 for the purpose of constructing and operating a competing cable system in Montgomery, Alabama. The company applied for a franchise on January 16, 1990. The franchise was granted by the city council on March 6, 1990 and was formally accepted by the company on April 4, 1990. Construction began that summer and the first subscribers were connected on October 19, 1990.7 Blount cited a good relationship with city council as one of the four criteria necessary for an overbuilder to survive.8 IHe said, "although we didn't have an outstanding relationship with the mayor, we had a very good relationship with city council."9 Montgomery city government is comprised of a mayor and nine city council members. By all accounts it is dominated by the mayor, Emory Folmar and City Councillor, Joe Reed.1o 7 "Descrlptlon 0f Company," Erenesal_fer_I!§on_§suare. Montgomery CableVision and Entertainment, Inc., September 8, 1992. Montgomery City’ Ordinance No.1§-29 formally’ granted Montgomery CableVision a franchise to construct and operate a cable television system in Montgomery, Alabama. 3 The other three criteria outlined by Blount are density, a reservoir of ill will against the incumbent, and the ability to obtain financing. 9 Blount interview. He also noted that the absence of a cable commission in Montgomery was an important factor in the company's decision to enter. "We wouldn't have done it if there were a commission . . . too much bureaucracy." w Councilman Rick McBride, Ed.D., interview by author, tape recording, Montgomery, Alabama, February 24, 1993. 82 Mayor Folmar is a Republican, active in politics at both the state and local level while Reed and Blount have strong connections with the Democratic Party. Reed is the second in command of the Alabama Education Committee, the state's most powerful lobby, is active in the Alabama Democratic Conference, the state's largest Afro-American political organization and is chair of the Board of Trustees at Alabama State University. Blount is Executive Director of the Democratic Party in Alabama.11 Because of Reed's influence at the state level, he and Folmar have developed a working relationship with respect to issues in Montgomery, despite their political differences. Further, there is a consensus that primarily because of the association between Blount and Reed, "the wheels had been greased" with city council before Montgomery CableVision formally filed its franchise application.12 Stephen Merelman, Reporter, The, Mentgemerx Afiyergieegzgeegnel, interview' by author, tape recording, Montgomery, Alabama, February 23, 1993. Gilbert interview. " According to Merelman, Blount was president of student government at the University of Alabama in the early 19708. The university is a "real breeding ground for politicians" in the state. Most of the state's democratic leaders have come out of "The Machine", an organization of fraternities and sororities at the University of Alabama that sponsors its own candidate for student government president. Blount was a product of this process and has been part of this network "since day one." u Blount, Rice, Gilbert and Merelman interviews. Jim Upchurch, "The Politics of Cable," uengggmezy_gity Magazine, 170, February 1, 1990, 13 and 14. 83 Prior to submitting the company's franchise application, Blount drafted and presented to council an ordinance whose primary purpose was to amend sections of the 1976 ordinance which "provided for the construction, operation, regulation and control of cable television systems."13 The ordinance in both its original and amended forms is explicitly nonexclusive stating, "nothing herein shall be construed to prevent the City Council from granting identical or similar franchises to more than one person "“ However, it also within all or any portion of the City. requires the city council to publish "its intention to award such a franchise or franchises", solicit the filing of Tom Kerver, "Genesis for Decision," gegleyieien October 8, 1990, 64 and 66. '3 ORDINANCE NUMBER 2:10, "AN ORDINANCE TO AMEND ORDINANCE NO. 50-76, AN ORDINANCE OF THE CITY OF MONTGOMERY ALABAMA ADOPTED JUNE 22, 1976, PROVIDING FOR THE CONSTRUCTION, OPERATION, REGULATION AND CONTROL OF CABLE TELEVISION SYSTEMS." The original ordinance, 50-76 was an enabling ordinance and set out the terms and conditions under which a cable system was to operate. In an undated letter from the city's cable committee to the mayor, it was recommended that Storer, the major stockholder of Montgomery Cable Television, Inc. be given a franchise to operate a cable system in Montgomery. According to Jack Gilbert, Storer's present general manager, there were three major contenders for the original franchise. On October 19, 1976 the city adopted Ordinance 101-75, "AN ORDINANCE OF THE CITY OF MONTGOMERY, ALABAMA, GRANTING A FRANCHISE FOR THE CONSTRUCTION, ACQUISITION, OPERATION, AND MAINTENANCE OF A CABLE TELEVISION SYSTEM WITHIN THE CITY LIMITS OF THE CITY OF MONTGOMERY, ALABAMA TO MONTGOMERY CABLE TELEVISION, INC." 1‘ An Ordinance No. 19:15 As amended by Ordinance No. 2:10 enacted January 16, 1990, "AN ORDINANCE OF THE CITY OF MONTGOMERY , ALABAMA PROVIDING FOR THE CONSTRUCTION, OPERATION, REGULATION AND CONTROL OF CABLE TELEVISION SYSTEMS." 84 competing applications, and accept applications "from all interested parties for a period of 60 days."15 The 1990 ordinance, No. 2:22, eliminated that requirement. As amended, Ordinance 50-76 states City Council may, by ordinance, award a franchise to construct operate, and maintain a cable television system within all or any portion of the City to any person . . . who makes application for authority to furnish a cable television system which com lies with the terms and conditions of the Ordinance.1 With the elimination of the requirement that the city open the franchising process to all interested parties, Montgomery CableVision was able to expedite the approval of its application.17 Perhaps more importantly, Ordinance 50-76 was also amended in the following ways: First, a paragraph (2) was added to Section 5. W which prohibited a franchisee from engaging in behavior which would "unlawfully damage any business competitor".1a Second, a paragraph (3) was added to Section 14. Beeee th;ge§_;e_§gbee:ibene which specified that "in no event “ Ordinance 50-76, Section 5 Paragraph 2. “ Ibid. The ordinance was passed by city council with an 8 to 0 vote on January 16, 1990. Reed was absent from the voting having left the meeting immediately prior to the ordinance's introduction. '" As amended, Ordinance 50-76 continues to require the city council to notify the public of its acceptance of a franchise application, to accept comments relative to the application, and to hold a public hearing. 'm Ordinance 50-76 as amended, Section 5.(2). 85 shall rates be established so low for any class of subscriber or for any geographic location as to prevent, discourage, restrict or diminish competition in the ”w The latter two amendments furnishing of cable services. subsequently became the basis of a suit filed against the City of Montgomery by Storer Cable Communications. In protesting the adoption of the amendments to the ordinance, Storer's attorney noted, that the amendment to Section 5 "attempts to create separate causes of action for undefined unlawful acts and to create new causes of action based not upon the violation of those statutes and regulations but upon the ordinance itself."m He also argued that the proposed change to Section 14 "attempts to create preferential treatment for a new cable operator and to prohibit competition in particular geographic locations."21 It is clear that the change is an attempt to create a cause of action in favor of a new cable operator against the existing franchisee Should the existing franchisee attempt to respond competitively to rates established by the new operator in limited geographic locations. w Ibid., Section 14. (3). Section 623 of the Cable Act of 1992 has a subsection (d) that, like the Montgomery ordinance, requires a uniform rate structure throughout a franchise area. 2° Thomas Lawson, Jr. , Attorney for Storer Cable Communications, "Statement to Montgomery City Council on January 16, 1990," 6. “ Ibid. 22 Ibid. 86 As it began to contract with programmers for services to offer on its system, Montgomery Cablevision encountered resistance from a number of providers including HBO, CNBC, Bravo, and TNT. As a result and on the advice of legal counsel, in August, 1990 Blount persuaded Councillor Rick McBride to introduce an additional ordinance designed to clarify the types of anticompetitive behavior prohibited by the January amendment to Section 5 of Ordinance 50-76.‘23 Among other things, this ordinance, No. 52:22, prohibited exclusive program contracts by making it unlawful for a cable operator, distributor, or program supplier "to restrain or attempt to restrain . . . the production, control or sale of program material or program services used in the provision of cable television service within the City. "2" The reluctance Montgomery CableVision encountered in its initial dealings with cable programmers was one of the 23 At the same meeting, McBride also introduced a resolution designed to "PROMOTE FAIRNESS AND COMPETITION IN CABLE TELEVISION." Although general in tone, the resolution's specific purpose was to expedite the attachment of Montgomery CableVision's equipment to utility poles. "Regular Meeting of the Council of the City of Montgomery," August 7, 1990. Brian Ponder, "City council presides over cable TV war," The_Alabame_IeurDal. August 8. 1990. 1a- “’ Ordinance A§:2Q, ”AN ORDINANCE OF THE CITY OF MONTGOMERY ALABAMA TO PROMOTE COMPETITION IN THE PROVISION OF CABLE TELEVISION SERVICE," Section 3, adopted August 21, 1990. The language used in the Montgomery ordinance prohibiting exclusive program contracts is quite similar to that employed in Section 628 of the Cable Act of 1992. 87 few things the company had failed to anticipate. According to Blount, "we had been led to believe by these boys in Troy that we could get programming through them."5’ The passage of the ordinances prohibiting exclusive program contracts was part of Montgomery CableVision's overall strategy to "pick the fight" with its competitor. According to Rice, Prior to this case, the only recourse a competitive operator had was a Sherman Act case . . . It could take years and cost millions of lives. You're talking about a major piece of litigation which a small operator can't afford. They can't pay the legal freight. This way, with the city actually making a law . . . it's against the law in Montgomery, Alabama to have an exclusive programming contract in restraint of trade. . . the monkey was put on TCI's back. It also put it (any litigation) on a faster track.“’ As was the case with the January, 1990 ordinance which made it possible for Montgomery CableVision to expedite the franchise process, Blount approached the mayor and city council privately prior to McBride's public presentation of the August ordinance. In an August 1, 1990 memorandum from Blount to Folmar and City Council, Blount outlined his 25'Blount interview. The "boys in Troy" to which Blount referred were a group of investors led by Harold Freeman. He had successfully overbuilt the Storer system in Troy, Alabama, a city about 40 miles south.of'Montgomery; It was Freeman who first approached Blount with the idea of overbuilding Montgomery. 2‘ Blount and Rice interview. The reference to TCI relates to the acquisition of Storer by Comcast and TCI in 1988. Subsequently, TCI has taken over control of all of the Storer systems. However, in Montgomery, the incumbent cable operator is most frequently referred to as Storer Cable Communications. 88 company's difficulties in obtaining programming. "We have been denied access to Turner Network Television (TNT), the Consumer News and Business Channel (CNBC), and the Sunday Night NFL package offered by ESPN."”' Blount argued that the reason that those programmers refused to deal with Montgomery CableVision was a result of "their common ownership by Storer's parent or by other coercion.W” Blount further argued that exclusive programming makes no economic sense since the programmers are presumably in the business of selling their programming to as many subscribers as possible. They are paid by cable system operators based on their number of subscribers and their advertising rates are based on the number of subscribers who have access to their programs . 29 And, We suspect that these programmers would not only comply with a Montgomery City ordinance prohibiting exclusive contracts--we feel they would welcome a city taking a stand that would begin to remove Big Cable's pistol from the side of their heads}30 In a separate letter to Folmar, Blount noted "our 27'"Memorandum from Bill Blount to Mayor Folmar and City Council Re: Anti-Competitive Tactics of Maj or Cable Operators and Programmers," August 1, 1990, 1. 2' Ibid. 29 Ibid. 3° Ibid. , 2. 89 attorneys have advised us . . . that the City Council possesses the legal power to enact a local ordinance prohibiting this abusive business behavior."31 In response to the adoption of the ordinance prohibiting exclusive program contracts, in September, 1990 Storer filed suit in federal court against the city of Montgomery and Folmar. The lawsuit alleged that both this ordinance and the amendment to Ordinance 50-76 adopted in January, 1990 requiring uniform pricing "were designed to prevent Storer from effectively and fairly competing for cable subscribers.‘” The suit also charged that contrary to their stated purpose, the ordinances will reduce rather than promote competition by unlawfully restricting the ability of programmers and distributors to use normal competitive tools such as exclusivity, which is common to many media industriesfi33 In November, 1990 Montgomery CableVision was allowed to intervene fully on behalf of the city because, the company's "ability to compete with Storer and fulfill the terms of its 3‘ Letter from Blount to Folmar, "Re: Ordinance to Promote Competition in the Provision of Cable Television Services," August 1, 1990. 1” Storer Cable Communications Press Release, September 6, 1990. 33 0 Ibid. Also, John Gerome, "Storer sues Montgomery over Cable TV ordinances." Wiser. September 7. 1990. 1a and 12a. "Storer Goes to Court over City Cable Rules," Breedeeeting September 24, 1990, 59. "Storer, ESPN Sue Montgomery Over Regulations," WW. September 24. 1990. 9- 9 0 own franchise agreement will be harmed if the court invalidates the two cable television ordinances.‘“ Although a summary judgement on the suit was issued in October, 1992, many questions remain unresolved. According to Gilbert, the summary judgement left the ordinance intact but removed a line which said if Storer had any exclusive contracts, the company would be in automatic violation and would risk the loss of its franchisefi35 Blount referred to the October ruling as "very confusing". The case is set for trial in August, 1993 to determine if Storer's exclusive contracts are in fact anticompetitive. Both sides concede that the litigation was extremely costly and that many of the issues in the suit will probably be rendered moot by the provisions of the 1992 Cable Act which require access to programming and a uniform rate structure . 3‘ Additionally, the suit substantially delayed Montgomery CableVision's entry into significant portions of the city because of the costs incurred by the company in litigation and because of the chilling effect the litigation had on capital. According to Blount, "capital wouldn't come to us 3‘ Stephen Merelman, "CableVision joins city in defending cable competition ordinances," Ine_51ebeme_lenznel, November 29, 1990, 2a. John Gerome, "CableVision joins city in lawsuit," The Hentgemer1_bdxertieer. November 29. 1990. 1b- 35 Gilbert interview. 1“ Cable Act of 1992, Section 623 (d) and Section 628. 91 until they could see a resolution of the court case . . .we couldn't raise any money."”' In both the Montgomery and Paragould cases, litigation proved to be an effective entry- delaying device. In his initial reaction to Storer's filing of the suit, Blount was quoted as saying, "‘This is just another diversionary tactic from a monopolist trying to keep competition out.'T” While the litigation may have been Storer's most effective tactic in its attempt to obstruct entry by a rival, it was not the only course the company pursued. W In his statement before city council on January 16, 1990 Storer's attorney, Thomas Lawson, Jr. argued that determining whether a second cable operator would be beneficial to the city of Montgomery could only be made "39 Lawson "after a thorough analysis and investigation. also noted that many cities had engaged consultants to help them determine the advisability of granting a second franchise. Additionally, he stated that "Storer would be willing to bear part of the costs of retaining a consultant of the City's selection, perhaps with similar backing from 37 Blount interview. 33 Elizabeth Hayes, "Storer files lawsuit to stop new city regulations," The_51ebeme_leg:nel, September 7, 1990, 1a. 3’ Lawson statement, 2. 92 Montgomery CableVision to make an appropriate study and come up with recommendations.""’0 In a March, 1990 letter to the mayor and city council, Michael S. Tallent, then President of Storer Cable Communications, followed up on Lawson's statement and presented seventeen questions outlining the issues which the company felt the city should consider prior to granting a second franchise. Many of the questions relate to Montgomery CableVision's assurances to the city and the company's commitment to construct and operate a competing cable system in Montgomery.“ Tallent's letter also states that "every major study ever done on a proposed overbuild has concluded that overbuilds are not economically viable in the long-run and do not result in sustained competition. ""2 In response to this letter, Blount addressed each of the seventeen questions, paying particular attention to the ‘° Ibid. , 4. ‘1 Letter from Michael S. Tallent, Storer Cable Communications to Folmar and members of the Montgomery city council, March 1, 1990. One of the questions posed by Tallent implicitly asked whether the principals in Montgomery CableVision were greenmailers whose real intent would.be "to sell the franchise for any intrinsic value it may have". ‘2 Ibid. The studies to which Tallent referred include an October 7, 1987 Touche Ross report to Dade County, Florida concluding that overbuilds in Dade County are not financially feasible and do not endure and a Telecommunications Management Corporation report to Hillsborough County, Florida that overbuilds are transient in nature and that participating operators generally suffer economically. 93 studies which found competition in cable to be infeasible in the long-run. Our study of competitive cable markets revealed that competing systems actually have a very good record of success. . . We must raise our own questions as to the objectivity and relevance of the studies cited by Mr. Tallent. Was Touche Ross and Company employed by Storer or Tele-Communications, Inc. (TCI) to perform these studies? Is Telecommunications Management Corporation itself a subsidiary of TCI?“3 Neither Lawson's statement nor Tallent's letter were able to persuade the city council to delay awarding Montgomery CableVision a franchise. While it is widely agreed that Blount had successfully "greased the wheels" of city government prior to submitting his franchise application, it has also been said that Storer was caught "asleep at the wheel.w“ Lawson's statement and Tallent's letter were only half-hearted attempts to delay Montgomery CableVision. Tallent's letter posed questions that were clearly addressed in Montgomery CableVision's application. For example, the letter asked "Has Montgomery CableVision committed itself to a construction plan in which service will be extended in a contiguous fashion, so as to prevent ‘cherry-picking' of high-density areas at the expense of areas that may be less profitable?"“5 In |icompliance with Ordinance 50-76, Montgomery CableVision's ‘“ Response of Blount, to Storer letter, March 6, 1990. “ Blount and McBride interviews. ‘“ Tallent letter, 3, question 13. 94 application outlined the company's intended geographical construction of the system It will be the policy of Montgomery CableVision 8 Entertainment, Inc. to construct its system in a manner that will serve all areas of the City equally. For this reason, the Company will institute a policy wherein it will construct one linear mile of plant to the west of its headend for each mile constructed to the east of its headend. No advantage will be afforded to residents living in any particular area of the City over residents living in any other section of the City.“ It is likely that the application detailed the company's construction plans as noted above in an effort to 1 anticipate and fend off any charges of "cream-skimming" that } might have been made by Storer. Through the research that the company did prior to submitting its franchise application, Montgomery CableVision was able to anticipate and counter most of the delaying tactics used by Storer. However, according to Blount, in addition to the problems associated with obtaining programming, one thing that wasn't anticipated was the resistance Montgomery CableVision met when it tried to attach its equipment to utility poles owned by South Central Bell."' Both Blount and Rice noted that while the pole ‘“ "Ordinance 50-76, Section 18(1)(c) Description of the System to be Built in Montgomery." W :9 u I 0 .. .0 0e ; 0 eu_e; - "0, MontgomeryCableVision and Entertainment, Incorporated. “’In Montgomery some of the utility poles are owned by Alabama Power Company and some are owned by the Regional Bell Operating Company. In his capacity as an investment banker, Mr. Blount had done some work with Alabama Power and as a result felt that he and his associates had done a good job of 95 attachment delay was a nuisance, "we didn't really have the kind of stuff we had been warned about.”“ In their first days as rivals both companies employed a variety of tactics as they attempted to attract or retain subscribers. In a letter to Lewis King, then General Manager of Montgomery CableVision, Gilbert detailed some installation complications that Storer had experienced since Montgomery CableVision had begun installation and hook-up to subscribers. "Such action is contrary to Alabama common law and statutory law and is violative of certain regulations of the Federal Communications Commission. We demand that Montgomery CableVision cease and desist its illegal activities . "‘9 The alleged illegal activities to which Gilbert referred were Montgomery CableVision's use of existing internal wiring to connect customers. Storer claimed that it had installed the wiring and as such the wiring belonged to Storer. King replied in a rather sarcastic letter to Gilbert. You mention one instance in which you say our crews used internal wiring, possibly installed by Storer to connect a new subscriber of ours. In such an instance, if you believe that a subscriber has breached his or her agreement with you concerning preparing the power company for what to expect. The issue of pole attachment was resolved in August, 1990 when city council passed resolution No. 212:22. See note 24, p. 86 supra. ‘3 Blount and Rice interview. ‘” Letter from Gilbert to King, October 11, 1990. 96 ownership of internal wiring to receive cable transmissions from another source, then your recourse is against the subscriber. If upon receipt of notice of termination by a subscriber, you wish to collect the internal wiring, please notify the subscriber of this fact and make arrangements to collect the wiring promptly. We will gladly replace the subscriber's internal wiring ourselves. Thank you for you letter, although it is unfortunate that you felt it necessary to draft this correspondence in the form of a demand letter. We appreciate your help during this transition period and you can be assured that we will do everything possible to make this process a smooth one for both companies and our subscribers. There was no further action by either party with respect to the ownership of internal wiring.S1 Subsequently Montgomery CableVision's salespeople were accused of telling customers that Storer's cable was not properly grounded and if lightning struck the cable, the customer's television set would explode. Rice noted that 5° Response of King, to Gilbert letter, October 16, 1990. 5‘ In Paragould, Arkansas a similar dispute arose over the ownership of internal wiring. The issue is discussed at length in Chapter IX. When asked about the ownership of internal wiring, Rice responded, "Here's how it works in the real world. We don't know who owns that wire. . . If they put it in they may own it. We don't know. We use the internal wiring of a house unless it's substandard. . . In the real world--they don't care if we use their wiring. We don't care if they use our wiring. If I've got one of their customers, they think one day they can get that customer back. If they get one of mine . . . The wire is just the medium. In the real world, it's a nonissue. But the courts around here have held it's the property owners who own the wire. Rice interview. 97 the salespeople were told to desist when company management learned of that tactic.52 In May, 1991, it was reported that Storer had refused to remove its equipment from an apartment complex that had signed an exclusive contract with Montgomery CableVision.53 By mid-1991 it appeared that the companies had entered into a truce. Despite the delay tactics and the chilling effect that litigation had on financing, as of late February, 1993, Montgomery CableVision was competing with Storer in approximately twenty percent of Montgomery.“; That competition takes place, to varying degrees, in terms of price, customer service and program offerings. 52 Rick Harmon, "Gloves coming off in city's cable duel," The_uentgemerx_edxertieer. January 29. 1991. 3- 53 Stephen Merelman, "Cable war heats up: Storer won't remove lines from apartments," The_hleheme_genrnel, May 1, 1991, 1a and 8a. John Gerome, "Apartment suit targets Storer Cable," The nentgemer1_Adxertieer. May 2. 1991. 4. 5‘ At the end of 1992, Montgomery CableVision passed 13,200 homes, had a gross penetration of 35 percent and an estimated market share of 50 percent. Montgomery CableVision and Entertainment, Inc., "Operating Projections 1993 through 1996." Gilbert, stated that he believes Blount and Rice seriously underestimated the make-ready costs of the overbuild and that the underestimation led to "tremendous" cost overruns in Montgomery CableVision's first year of operation. As a result, the company had been unable to overbuild as much of Montgomery as had been planned. 98 Wings As detailed in Chapter VI, Smiley noted that when considering entry into a cable television market, the potential entrant should anticipate that the incumbent will reduce its price to meet the competitive challenge.”’ In their studies Hazlett and genehmeze;_3eeeereh found evidence of selective price cutting in areas where there was direct competition in cable television delivery. It is quite likely that Blount and Rice anticipated that Storer would engage in some form of selective price cutting and as a result they drafted the uniform pricing ordinance to circumvent the incumbent's ability to employ this type of strategic behavior. To date there has not been an all-out price war waged in Montgomery. In addition to the passage of the uniform pricing ordinance, there are at least two reasons for this. First, from the outset Montgomery CableVision recognized that it couldn't fight and win a price war. This despite the fact that it argues that its costs per subscriber are much lower than that of the incumbent.“’ Second, while 55. see Chapter VI, p. 59. 5‘ Rice interview. He said that although "big cable" claims to be the low cost provider, "the one thing they don't toss into the mix in any of the studies you see, they don't throw in what they paid for their cable systems. If you look at the proformulas from the standpoint of who's the low cost provider, they're amortizing debt on $2800 per subscriber that they 100 percent financed in 1987, in the glory years . . . We don't have the cost basis of an M80. Everything in this system: operating losses, depreciation, everything-~we've