Why Fierce Price-Cutting Could Be Gone In A Flash

Competition in communications seems cutthroat. Companies are invading each other's turf, and prices are falling. You can make a video-phone call to Australia via the Internet, chat for three hours, and never pay a penny. Citing all this hubbub, AT&T Inc. argues that there's no threat of re-monopolization even as it bids to reunite five of the eight companies that emerged from the 1984 breakup of the Bell System.

Look out, though. The competition we're seeing is just a phase, and an unstable one at that. The key thing about communications networks is that they're very costly to build, but once they're built, it's cheap to add customers to them. This industry structure has special economic properties. At times it produces price wars. At other times it leads to merger waves, resulting in a small number of competitors with the ability to raise prices and garner big profits. This time, the transition from ruinous competition to over-consolidation could be breathtakingly rapid.

Put yourself in the capacious cowboy boots of Edward E. "Big Ed" Whitacre Jr., the CEO of AT&T (T ). He's investing heavily in fiber and wireless networks. He knows the only way he can make a return on his investment is if many, many customers use his network. For him, the worst possible outcome is that lots of other bigfoot CEOs with competing networks, like the cable execs, grab so much traffic that he can't recoup his multibillion-dollar investment.

In this delicate situation, Whitacre and his rivals have used two main strategies over the years. One has been to cut prices to fill up their networks. Remember, additional customers are cheap to serve, so there's room to cut. In the battle for market share, companies like AT&T will remain tempted to keep cutting prices as long as the customers they attract make at least a little contribution to covering the hefty up-front cost of building the network. But here's the trouble: Unbridled competition eventually pushes prices to the point where total revenue no longer covers total costs. Companies that were once gungho lose interest in making further investments. They may even have trouble paying off the debt from past rounds of expenditure.

The alternative strategy, which Whitacre and others have also pursued, is consolidation. As long as regulators permit, the strong buy the weak and extinguish the excess capacity. As competition eases, the survivors can raise prices and restore their profitability. (Good for shareholders; bad for customers.) Profits may even get so rich that new entrants are drawn in, in which case price-cutting will once again predominate. Alternatively the barriers to entry may be so high that the market settles into a kind of cozy club.

Between these two scenarios, where are we right now? Maybe halfway. There's obviously still lots of competition, but there are also lots of mergers. More and more, the strife is between a handful of giants. It's easy to imagine a merger next between, say, Sprint Nextel Corp. (S ) and one of the big cable guys like Comcast Corp. (CMCSA ) or Time Warner Inc. (TWX ), with whom it's co-marketing. As for the Bells, Nicholas Economides, an economist at New York University's Stern School of Business, worries that if the AT&T-BellSouth deal is approved, "we are one more merger away from full monopoly."

For consumers, the best hope is a steady stream of technological breakthroughs that prevents incumbents from ever getting a lock on the market. Microwave technology allowed MCI to crack the Bell System. Then there was fiber, and now the Internet. But at present, the forces of consolidation are strong.

By Peter Coy

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