TABLE OF CONTENTS

Executive Summary

I. Introduction

II. The Proposed Merger

III. The Economic Theory of Mergers

IV. How the Merger Will Be Assessed

V. Assessing the Merger
Question 1: Does the merger significantly increase concentration in the long-distance and Internet backbone markets?
Question 2: Does the increased concentration have anti-competitive effects?
Question 3: Can entry quickly and materially counteract the anti-competitive effects of the Merger?
Question 4: Are efficiencies from the merger attainable by other means?

VI. Remedies

VII. Conclusion

Executive Summary

Mergers in the information transport sector have become almost commonplace as new rivals position themselves against incumbent long-distance and local phone companies. Although many such mergers can be beneficial, they can also be detrimental to consumers. The proposed merger of MCI WorldCom and Sprint is a case in point. While the merger of these two firms would produce a very large company, size by itself is not alarming. Nor is the cross-industry rivalry that will accompany the merger alarming; it may eventually lead to a broader definition of the industry. What is alarming about the proposed merger is the increase in market power-as evidenced by concentration ratios-that the merged company will have by combining two large, well-known firms serving similar geographic markets and providing similar customer groups with similar services. With one fewer competitor in those services, the telecommunications market will be just one merger away from complete dominance by a single firm.
The Department of Justice and the Federal Trade Commission, which have been entrusted to assess how a merger will affect the general welfare, have formulated a set of basic questions that must be addressed to assess the benefits and risks of a proposed merger. The questions, and how they apply to this merger, can be summarized as follows:

1. Does the merger significantly concentrate the market?
Based on an analysis of data from the Federal Communications Commission and others, the conclusion can be drawn that the long-distance market is presently an extremely concentrated market that will become even more so after the proposed MCI WorldCom/Sprint merger. The same finding is true for the Internet backbone market.

2. Does any resulting concentration pose anti-competitive effects?
The evidence from the widening gap between prices and costs and the presence in the industry of supernormal profits suggest that competition is already weak in the long-distance market. In the already-concentrated wholesale Internet backbone market, supply is falling behind demand, prices are higher in markets with fewer competitors, and the pace of technological change seems to have been affected. Increased concentration will only intensify the anti-competitive effects in both of these markets.

3. Can entry quickly and materially counteract these anti-competitive effects?
Substantial barriers to entry currently make the telecommunications market incontestable. The brand name barrier makes it difficult for new companies to gain immediate recognition to compete with established companies; the regulatory barriers have acted to bar the way for the baby Bells (the Regional Bell Operating Companies) to compete in long-distance and data services markets; the sunk cost barrier appears to be precluding new firms from entering the market and existing firms from expanding; and the network effect appears to be allowing a few firms to dominate long-distance and data services markets. Moreover, the argument of MCI WorldCom and Sprint that excess capacity in those markets makes them contestable is a weak one. Such capacity is highly concentrated among a few suppliers, and most likely reflects future planning for the growth of demand.

4. Are the efficiencies from the merger obtainable by other means?
With no further efficiencies to be obtained from economies of scale in the long-distance and Internet backbone markets, it is best to leave the companies unmerged in those markets and to promote competition in them.
In the wireless and local exchange service markets, however, the merger will most likely achieve synergies that will benefit consumers, thus, no action should be required of the merging companies to either exit or divest the wireless or local service market components, because those are part of an end-to-end merger and per se do not produce obvious risks to consumers. On the other hand, the merger of Internet and long-distance service components poses severe problems, because those parallel mergers will lead to concentrated markets that already show signs of being non-competitive. Those concerns are greater in the market for wholesale services than in retail, although retail long distance is being stunted as a direct result of the wholesale control by a few suppliers.

To remedy the increase in market power that would lead to a reduction in competition, the following steps are recommended in the Internet and long-distance backbone markets:

• Divestiture of Sprint’s Internet backbone network, including the fiber and equipment, data centers, personnel, systems, documentation, and all customers receiving Internet wholesale services.
• Divestiture of Sprint’s long-distance backbone network, including the fiber and equipment, network centers, personnel, systems, documentation, and all customers receiving long-distance wholesale services; and
• Divestiture of Sprint’s ATM network, including the fiber and equipment, large business centers, personnel, systems, documentation, and all large-business customers receiving these services.

Yet divesting a portion of the merging company’s network is the minimum required to address concerns with the merger’s potential harms. A more proactive regulatory response is for policy makers to reject the merger and to do their utmost to remove as quickly as possible barriers to entry in the wholesale data and long-distance markets. Specifically, the barriers preventing the baby Bells from entering the wholesale end of those markets should be ended immediately, thereby minimizing the risk to consumers that companies in the long-distance and Internet backbone industries will have sufficient market power to earn supernormal profits. Policy makers must maximize consumer welfare and protect competition instead of protecting competitors.

INTRODUCTION

Competition has begun to develop slowly through a number of avenues in the information transport sector-the broad set of industries transporting voice, data, and video to consumers. One of those avenues is regulatory policy. Slow but significant progress has been made since the signing of the Telecommunications Act in 1996, the purpose of which was to deregulate the communications sector so as to speed the benefits of competition to consumers. Since the signing of the Act into law, local markets have begun to open up. By our estimate, 10 million access lines have been put in place by competitive carriers, an estimate that excludes competition from wireless, broadband, and other l
ocal bypass services. Also, since the Act’s signing, there has been a slow removal of the regulatory barriers imposed on the Regional Bell Operating Companies (RBOCs) by the Modified Final Judgment (MFJ) to keep them out of long distance. With the entry of Bell Atlantic into the New York long-distance market, limited long-distance competition is about to begin there.

In the midst of the developing competition, entrants and incumbents have begun to realize the need to add capabilities similar to those of their rivals. The quickest route is through mergers, which allow companies to become formidable players in various parts of the information transport sector quickly. Some mergers can increase a company’s geographic reach, while others can make small-scale operations into large-scale ones. Some firms can offer a less-expensive, better, and wider selection of service to consumers through joint production, while others can leverage their existing networks for better capacity utilization.

Some of the mergers, though, may slow, if not completely halt, competition. One of them appears to be the merger proposed between MCI WorldCom and Sprint. While the merger of those two firms would produce a very large company, size by itself is not alarming. After all, big is sometimes better, especially in network economics. Nor is the cross-industry rivalry that will accompany the merger alarming; it may eventually lead to a broader definition of the industry. What is alarming about the proposed merger is the increase in market power-as evidenced by concentration ratios-that the merged company will have from combining two large, well-known companies serving similar geographic markets and providing similar customer groups with similar services. With one fewer competitor in those markets for such services, the telecommunications market will be just one merger away from complete dominance by a single firm.

Because the proposed merger of MCI WorldCom with Sprint raises concerns about future competition in the information transport sector, this study investigates the parts of the merger posing the most risk to consumers in that sector. Specifically, the study focuses on markets within the information transport sector in which each of the merging companies has a sizable presence, and in which each overlaps with the other by supplying similar services. The fundamental question this study addresses about the effects of the merger on those markets is, on the one hand, whether the merged company will have so much market power that the merger will prove detrimental to the interest of consumers, or, on the other, whether the merged company will be so much more efficient that consumers in those markets will on balance benefit. To answer that, the study analyzes the following areas of inquiry:

• the effect of the merger on industry concentration;
• the effect of the merger on competition;
• the risks to consumers from the merger;
• the ability of market competition to mitigate those risks; and
• the use of other means to achieve the benefits of the merger.

The outline of the study is as follows: Section II will discuss the components of the proposed merger. Section III will discuss the economic theory that will be used to analyze the merger; that section can be skipped by those who are familiar with economic theory of mergers. Section IV will discuss the guidelines that the Department of Justice (DOJ) and the Federal Trade Commission (FTC) have issued about mergers; those guidelines provide a framework for analyzing the areas of inquiry above. Section V will analyze how the merger meets or fails to meet the guidelines within the context of the economic theory of Section III. Based on that analysis, Section VI will make a series of recommendations on the merits of the merger. Section VII contains a brief conclusion.