The Welfare Impacts of Competitive Telecommunications Supply: A Household-Level Analysis by

Expanding competition in all aspects of telecommunications supply makes it increasingly difficult to maintain cross-subsidies in the supply of local telecommunications services. A large cross-subsidy flows from long-distance telephone service to local exchange service. Approximately 45 cents of every dollar spent on a long-distance call is paid to the local exchange providers at both ends of the call. A substantial fraction of these payments are in excess of costs of providing local access. The purpose of this paper is to assess the household level consumption and welfare impacts of eliminating this cross-subsidy by increasing the price of local exchange service with and without an accompanying decrease in the price of long-distance service. Using household-level data from the Bureau of Labor Statistics' Consumer Expenditure Survey, this paper estimates two types of complete systems of consumer demand functions for local telephone service, long-distance service, food, clothing and other nondurable goods. Both models account for zeros in the consumption of any of these five goods in manner that can be rationalized as consistent with household-level utility-maximizing behavior. The first system—the interior solution model—treats all observed expenditure shares, including zeros, as the interior solution to the household’s budget-constrained utility-maximization problem. The second system—the boundary solution model—explicitly recognizes that observed zero expenditure shares may be the result of nonnegativity constraints on the consumption of all goods when the household makes its utility-maximizing choices. With each of these demand systems, we compute the welfare impacts of various local and longdistance telephone service price changes using household-level compensating variation. For both demand systems, increasing the price of local service is found to be increasingly burdensome to the lower total expenditure households, even when it is coupled with an equal percentage decrease in the price of long-distance service. On the other hand, high-expenditure households find that increases in the price of local service coupled with decreases in the price of long-distance are net welfare improving, and increasingly so as total household expenditures on non-durable goods increases. Because the Consumer Expenditure Survey is a random sample from the US population of households, we can compute an estimate of the average US household-level welfare loss or gain associated with each price change scenario. We find that for the model that explicitly accounts for the non-negativity constraints on the consumption of all goods, the boundary solution model, the mean welfare change associated with all of the price change scenarios is substantially more negative, particularly for households in the lower tail of the total expenditures distribution. For the single price increase for local service scenarios, the boundary solution model also predicts greater welfare losses. For those scenarios balancing local price increases with long-distance price decreases, the boundary solution model yields significantly larger welfare losses for households experiencing welfare losses and significantly smaller welfare gains for households experiencing welfare gains. These results point out the importance of properly modeling the impact of zeros in consumption when making welfare assessments concerning the pricing of telephone services to households. The tremendous amount of heterogeneity in magnitude of the welfare impacts of these price changes, particularly at the low end of total expenditure distribution, points out the necessity of a household-level analysis for obtaining a complete description of welfare impacts of telephone services price changes. For example, effective January 1, 1995, the California Public Utilities Commission raised Pacific Bell’s price of local 1 residential service by approximately 35 percent (California Public Utilities Commission, 1994). Recently, US West made an unsuccessful request to the Arizona Corporation Commission to approve a revenue-neutral rate re-balancing plan that would shift some $20 million in revenue away from intraLATA toll and onto local exchange service. 1