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If you need the complete document, download the WordPerfect version or Adobe Acrobat version, if available. ***************************************************************** FCC 94-235 Before the FEDERAL COMMUNICATIONS COMMISSION Washington, D.C. 20554 In the Matter of ) ) Implementation of Section 19 of the ) Cable Television Consumer Protection ) and Competition Act of 1992 ) CS Docket No. 94-48 ) Annual Assessment of the Status of ) Competition in the Market for the ) Delivery of Video Programming ) FIRST REPORT Adopted: September 19, 1994 Released: September 28, 1994 By the Commission: Table of Contents Paragraph I. Introduction. . . . . . . . . . . . . . . . . . . . . . . 1 A. Evolving View of Competition in the Market for the Delivery of Video Programming. . . . . . . .2 B. Scope of the Report . . . . . . . . . . . . . . . . .7 C. Summary of Findings . . . . . . . . . . . . . . . . 11 II. Cable Industry Performance Since 1990 . . . . . . . . . . 17 A. Performance from 1990 to 1993 . . . . . . . . . . . 18 B. Recent Developments. . . . . . . . . . . . . . . . . 28 III. Status of Existing and Potential Competitors to Franchised Cable Systems37 A. Market Definition. . . . . . . . . . . . . . . . . . 37 1. The Relevant Market Concept . . . . . . . . . . 38 2. The Commission's Evolving Approach to Market Definition for Cable Services. . . . . 41 3. The 1992 Cable Act. . . . . . . . . . . . . . . 46 4. Implications of Market Definition for This and Future Reports . . . . . . . . . . . 49 B. The Status of Existing Competitors to Franchised Cable Systems . . . . . . . . . . . 54 1. Overbuilders. . . . . . . . . . . . . . . . . . 54 2. Direct-to-Home Satellite Services . . . . . . . 61 a. Direct Broadcast Satellite (DBS) . . . . . 62 b. Home Satellite Dishes (HSDs) . . . . . . . 71 3. Terrestrial "Wireless" Cable -- Multipoint Multichannel Distribution Service (MMDS) . . 78 4. Satellite Master Antenna Television Systems (SMATV) 91 5. Broadcast Television Service. . . . . . . . . . 97 C. Other Actual or Potential Competitors. . . . . . . 103 1. Local Exchange Carrier (LEC) Entry. . . . . . 103 2. Local Multipoint Distribution Service (LMDS). 121 3. Low Power Television (LPTV) . . . . . . . . . 126 4. Electric Utilities . . . . . . . . . . . . . 131 5. Video Cassette Recorders (VCRs) . . . . . . . 134 IV. Market Structure Conditions Affecting Competition . . . 136 A. Horizontal Concentration in the Cable Industry . . 137 1. Status of Concentration in the Cable Industry 141 2. Competitive Effects of Horizontal Concentration 148 3. Conclusion. . . . . . . . . . . . . . . . . . 156 B. Vertical Integration in the Cable Industry . . . . 157 1. Status of Vertical Integration in 1994. . . . 161 2. Competitive Effects of Vertical Integration . 173 a. Competitive Access to Programming. . . . 173 b. Commission Rules Promulgated to Assure Diversity in Programming. . . . 187 3. Conclusions . . . . . . . . . . . . . . . . . 191 C. Nature of Technical Changes Affecting Cable Systems 194 V. Status of Competition in the Market for the Delivery of Video Programming . . . . . . . . 201 A. Extent of Competition and Assessment of Market Performance 201 1. Overview. . . . . . . . . . . . . . . . . . . 201 2. Market Performance Indicators . . . . . . . . 204 a. Pricing Above Competitive Levels Indicates Market Power . . . . . . . . 205 b. Other Indicia of Market Performance. . . 220 c. Conclusion . . . . . . . . . . . . . . . 227 3. Existing and Potential Impediments to Competition228 a. Strategic Behavior to Deter Competitive Entry229 b. Regulatory Impediments . . . . . . . . . .239 c. Potential Technological Bottlenecks. . . .242 4. Extent of Competition in the Multichannel Video Programming Distribution Market . . . .246 B. Future Considerations and Recommendations for Promoting Competition to Cable Systems . . . . . .247 VI. Administrative Matters. . . . . . . . . . . . . . . . . 260 Appendices A. List of Commenters B. Glossary of Technical Terms and Acronyms C. Cable Industry Performance D. Local Exchange Carrier Proposals E. Market and Technical Trials, Grants and Pending Applications for Video Dialtone F. Description of Program Access Cases Resolved (as of September 19, 1994) G. Horizontal Concentration, Vertical Integration and Program Access (Successor to Appendix G of the 1990 Report) H. Economic Concepts for Assessing the Extent of Competition in Video Programming Distribution Markets I. Evaluating Market Power by the q Ratio I. INTRODUCTION 1. Pursuant to the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act" or "the Act"), the Commission is required to report to Congress annually "on the status of competition in the market for the delivery of video programming." This report (the "Report" or the "Competition Report") is the first of these annual competition studies. A. Evolving View of Competition in the Market for the Delivery of Video Programming 2. In the ten years since Congress enacted the first major statute addressing the cable industry -- the Cable Communications Policy Act of 1984 -- the view of competition in the market for the delivery of video programming has evolved, both in Congress and at the Commission. As the Commission recognized in the report on competition in the cable television industry that it issued in 1990, Congress enacted the 1984 Cable Act to encourage the growth of cable systems, the development of cable services and the provision of diverse sources of information. Accordingly, one of the primary purposes of the 1984 Cable Act was to "promote competition in cable communications and minimize unnecessary regulation that would impose an undue economic burden on cable systems." 3. To fulfill this Congressional purpose, the 1984 Act imposed various limitations on the authority of local government entities to regulate cable services and, in particular, permitted regulation of basic cable rates only where, pursuant to Commission-established criteria, "a cable system is not subject to effective competition." The Commission later determined that "effective competition" existed when at least three unduplicated broadcast television signals were "available" to the cable community. In essence, that determination deregulated the rates of approximately ninety-seven percent of all cable franchises. 4. The 1984 Cable Act was a success in many ways. The number of communities and homes served by cable grew dramatically, channel capacity increased, and new programming was created. However, as the Commission found in its 1990 Cable Report, there was little competitive constraint on cable market power after passage of the 1984 Act, and cable system operators were able to collect monopoly profits through the imposition of significant rate increases on subscribers. 5. In response to those trends, Congress passed the 1992 Cable Act, which in essence, re-regulated the cable industry. In enacting the 1992 Cable Act, Congress found that "[t]he average monthly cable rate has increased almost 3 times as much as the Consumer Price Index ["CPI"] since rate deregulation [under the 1984 Cable Act]." Congress also found that without competition, there was "undue market power for the cable operator as compared to that of consumers and video programmers," and that "the cable television industry has become a dominant nationwide video medium." However, Congress specifically articulated as a central and critical goal of the legislation a "[p]reference for competition," as opposed to rate regulation of cable systems. Accordingly, the 1992 Act generally provides that where a cable system is subject to effective competition, its rates shall not be subject to governmental regulation. 6. As the Commission recognized in the NOI, the 1992 Cable Act's regulatory scheme serves as a "transitional mechanism until competition develops and consumers have adequate multichannel video programming alternatives." Moreover, promotion of the emergence of effective competition through the entry of alternative distribution technologies is a critical element of the regulatory framework mandated by Congress. The Commission has adopted rules implementing this mandate; in particular, regulations requiring that programming be made available to competing distributors on non-discriminatory terms, and prohibiting cable operators from discriminating against unaffiliated programmers on the terms and conditions of carriage. In this manner, the Commission has sought to inhibit anticompetitive abuses and to foster the emergence of a competitive market for the delivery of video programming to consumers. B. Scope of the Report 7. Through this Report and future reports, the Commission intends to provide Congress with information regarding the state of competition in the market for the delivery of video programming, with a particular emphasis on the cable television industry. Accordingly, this Report provides data and information on: cable industry performance (Section II); the status of entry by Multichannel Video Program Distributors ("MVPDs"), including those that use technologies other than cable (Section III); and structural issues affecting entry, such as vertical integration, horizontal concentration, and technological advances (Section IV). Also included in Section IV are preliminary assessments of the impact of the 1992 Act and of the Commission's regulations on access to video programming services by competing MVPDs. 8. Section V of the Report contains the Commission's analysis of the extent of competition in the market for the delivery of video programming, and an assessment of market performance. A discussion of future action by the Commission to study the cable industry and to prepare for future reports is also included in Section V. 9. In preparing this Report, the Commission has been mindful of the rate regulation provisions of the 1992 Act, which exempt from rate regulation cable systems subject to "effective competition." As described more fully below, the 1992 Cable Act defines "effective competition" to exist when: (a) a franchise area is served by at least two unaffiliated MVPDs, each of which offers comparable video programming to at least 50% of the households in the franchise area; and (b) at least 15% of the households in the franchise area subscribe to service from MVPDs other than the largest one. The statute also defines effective competition to exist when fewer than 30% of the households in the franchise area subscribe to the cable system, or when an MVPD operated by the franchising authority offers service to at least 50% of the households in the franchise area. The term "MVPD" is defined in the 1992 Act as "a person, such as, but not limited to, a cable operator, a multichannel multipoint distribution service ["MMDS"], a direct broadcast satellite ["DBS"] service, or a television receive-only ["TVRO"] satellite program distributor, who makes available for purchase, by subscribers or customers, multiple channels of video programming." 10. As explained in Section III.A.4, infra, the competitive status of MVPDs is an appropriate starting point for this Report. However, Congress charged the Commission with annually reporting on the "status of competition in the market for the delivery of video programming." In the Commission's view, obtaining a complete picture of the status of competition requires the Commission to look beyond MVPDs to other technologies not explicitly included within the statutory definition that may have a constraining effect on cable system practices. Moreover, to fulfill its statutory mandate, the Commission believes it should also look beyond the "effective competition" standard of the 1992 Cable Act, which is a bright-line test used to determine when a particular cable system's rates may be deregulated. Accordingly, in this Report and future reports, the Commission intends to provide a fuller economic analysis of the industry, rather than simply report on the status of "effective competition" in each franchise area in the country. C. Summary of Findings 11. In this Report, the Commission makes the following findings: 12. Industry Growth. Between the end of 1990 and the end of 1993, cable industry subscriber penetration, average system channel capacity, the number of programming services available, cable industry revenues, expenditures on programming, and capital investment all increased. Data for the first half of 1994 that is available from companies that file reports with the Securities and Exchange Commission ("SEC"), while incomplete, suggest that subscribership and capital investment have increased for those companies from 1993 levels. In addition, ten of the fifteen largest cable system operators for which information is publicly- available, including the two largest such companies, have reported increases in cable service revenue for the first half of 1994, while the other five have reported decreased cable service revenues. 13. Cable Market Power. The market for the distribution of multichannel video programming remains heavily concentrated at the local level, and for most households, cable television is the only provider of multichannel video programming. Cable systems continue to have substantial market power at the local distribution level. 14. Horizontal Concentration. Since 1990, there has been a moderate increase in the horizontal concentration of cable multiple system operators ("MSOs") nationwide and, if consummated, several recent proposed mergers will result in increased "clustering" or regional concentration of cable system ownership. 15. Competitive Entry. There are presently only a few scattered areas of the country in which local cable systems face direct competition via "overbuilding" (where more than one cable system has cable lines passing the same homes). Providers using alternative video programming distribution media have not yet reached the subscribership levels necessary for the Commission to conclude that vigorous rivalry currently exists in the market for multichannel video programming distribution. However, alternative distribution media have made substantial strides since the 1990 Cable Report. In particular:  DBS service, merely a vision in 1990, is now operational, and is being rolled out around the country. It has been suggested that initial demand for the equipment necessary to receive DBS service has exceeded supply;  MMDS or "wireless" cable systems are increasing in number, and are now obtaining the financial resources necessary for growth and expansion;  Satellite Master Antenna Television ("SMATV") systems are growing in terms of numbers of systems and subscribers;  in 1992, the Commission adopted a regulatory framework that permits companies providing local telephone service (commonly referred to as "local exchange carriers" or "LECs") to construct and operate in their service territories common carrier platforms through which multiple entities can provide programming and other services to subscribers. Pursuant to that video dialtone ("VDT") framework, the Commission has authorized five technical or market trials and one permanent VDT service offering. In addition, there are twenty-three applications pending to provide permanent VDT service in other communities which, if granted, would allow service to 8.5 million homes; and  other possible technological and regulatory advances have been identified that might allow broadcast television, low power television, Local Multipoint Distribution Service ("LMDS") and/or electric utilities to enter into the market for the distribution of multichannel video programming. 16. Vertical Integration. Vertical integration in the industry has remained at roughly the same level as in 1990, with cable MSOs continuing to invest in video programming vendors. The Commission anticipates that this investment will continue, and that the Commission's program access and program carriage rules will remain needed to guard against abuses that may result from such investment. Generally, those rules seem to have been successful in ensuring the availability of programming. Several firms that package programming for distribution to home satellite dish ("HSD") owners, however, have alleged that they continue to pay higher prices for programming than comparable cable operators. II. CABLE INDUSTRY PERFORMANCE SINCE 1990 17. In this section of the Report, the Commission addresses the basic performance of firms that own or operate franchised cable systems. This includes analysis of the following characteristics: (1) output -- the current amount of cable industry service that is being produced, and recent trends in that production; (2) quality -- the nature of the service, which is related to output since higher quality services are more highly valued and can, therefore, be thought of as more output; (3) revenue -- the income that is earned from the industry's output; (4) expenditures and cash flow -- the costs associated with the production of the industry's output; (5) capital investment -- the amount of investment by the companies in the industry; and (6) transactions -- the changes in ownership and trend towards consolidation in the industry. Section V of the Report contains a discussion of indicia of market power, including cable industry pricing, which is also an important indicator of industry performance. A. Performance from 1990 to 1993 18. Cable Industry Output. Since the Commission last reported on the status of competition in this market in 1990, the cable industry has continued to expand. The number of homes that could receive cable service ("homes passed") grew to 92.9 million in 1993 (up from 86 million in 1990), which was over 96% of all television households in the United States. 19. With cable services available to more homes than ever before, the total number of households subscribing to basic cable services has increased to 57.4 million households, which is almost 60% of the television households in the United States (up from 51.7 million households and 55.8% of television households in 1990). The industry's penetration (which measures the percentage of households passed by cable that choose to subscribe to basic cable services) increased by 2.78% since the 1990 Cable Report, so that nearly 62% of all households that could receive basic cable in 1993 purchased such services. 20. Attributes of Cable Industry Service. The attributes or "quality" of cable services are multi-dimensional, and thus, no single measure of quality is available. Possible indices of cable service quality are the channel capacity of cable systems and the quantity of cable programming. Since 1990, average channel capacity has noticeably increased in the industry. Cable systems with the capacity for providing thirty or more channels accounted for over 77% of all cable systems for which information was available in 1993. At the same time, systems that have capacities of twelve or fewer channels, which accounted for over 22% of all systems in 1987, accounted for only a little over 7% of all systems last year. As a result, by the end of 1993, nearly 97% of all subscribers for which information is available received service from systems that could provide at least thirty channels. 21. Since the Commission issued the 1990 Cable Report, there has also been noticeable growth in the number of cable programming choices. The number of basic programming networks grew by over 18%, from sixty-one at the end of 1990 to seventy-two at the end of 1993. The number of pay-per-view networks nearly doubled, from seven in 1990, to thirteen at the end of 1993. Overall, the number of programming networks increased by over 29%, from seventy-seven at the end of 1990, to ninety-nine at the end of 1993. 22. Cable Industry Revenue. The cable industry continued to generate increased amounts of revenue between 1990 and 1993. It appears that the cable industry generated $22.94 billion in total revenue in 1993, which was over 28% more than the $17.86 billion it generated in 1990. Of the 1993 amount, $13.55 billion, or over 59%, came from basic service tier programming. Revenue from pay-per-view programming increased 102% from $253 million to $512 million over the same time period. 23. Advertising revenue has become an increasingly important source of revenue for the cable industry. Last year, cable operators' revenue from local and national spot advertisement volume reached $1.064 billion, up from $628 million in 1990. Accordingly, advertising services provided cable systems with over 69% more revenue in 1993 than was the case in 1990. 24. Cable Industry Expenditures and Earnings Before Interest, Taxes, Depreciation, and Amortization. Cable expenditures on programming rose by more than 25% between 1990 and 1993. It appears that most of that increase came from substantial increases in expenditures for basic programming, which increased by 55% from $1.4 billion in 1990, to nearly $2.2 billion in 1993. Expenditures for other programming appear to have remained nearly constant over the same time period. 25. Measurements of earnings before interest, taxes, depreciation, and amortization ("EBITDA"), which people in the industry commonly refer to as "cash flow," are often used to value the economic health of industry firms. It is difficult to generate such a measure for the cable industry as a whole because a significant percentage of subscribers are served by systems that do not publicly report financial information. Paul Kagan Associates, Inc. ("Kagan") has produced industry-wide cash flow estimates of $5 billion in 1987, $7.8 billion in 1990, and $10.1 billion last year. For the purposes of this Report, the Commission has also produced an estimate of industry-wide cash flows for the same years. Based on the Commission's estimates, it appears that the industry generated cash flows of over $4.8 billion in 1987, $7.9 billion in 1990, and $10.5 billion in 1993. It also appears that the industry had a cash flow per basic subscriber of $164.29 in 1993, which would represent an increase of 19% for the period between 1990 and 1993. Moreover, it appears that the industry's cash flow represented over 46% of its total revenue in 1993, which was a 4.4% increase over 1990. 26. Capital Investment. In 1990, the industry invested nearly $3.0 billion in construction. In 1991 and 1992, however, investment in construction dropped off, to approximately $2.2 billion in each of those years. The cable industry's construction investment rebounded in 1993, however, to almost the same level as in 1990, nearly $3.0 billion. 27. Cable System Transactions. In 1990, systems with an aggregate value of $1.07 billion were sold, compared with the aggregate value of $11.21 billion for systems sold in 1987. In 1993, however, the systems sold had an aggregate value of over eight billion dollars, even though the total number of transactions declined from 1990. The dollar value per subscriber of systems sold increased by over five percent during the same years, from $2049 in 1990, to $2160 in 1993. B. Recent Developments 28. In this section of the Report, the Commission provides data describing subscriber growth, revenue, capital investment and cable system transactions for the first half of 1994. The figures for subscriber growth, revenue and investment are taken from statements of cable system operators that publicly report such information in filings with the SEC. Those companies accounted for service to approximately fifty-five percent of all basic subscribers at the end of 1993, and they earned approximately fifty percent of all cable service revenue that year. For many other MSOs, however, most of the relevant information is not publicly available, particularly in the case of privately-owned companies, which include most of the smaller MSOs. Consequently, the information reported in the following discussion of recent developments is not necessarily representative of recent developments for the entire industry. 29. Subscriber Growth. The record indicates that the publicly-reporting companies have experienced continued growth in the number of basic subscribers over the first six months of 1994. MSOs that have released reports this year that indicate recent subscriber growth include:  the industry's largest MSO, TCI Communications, Inc. ("TCI"), which reported that it added 150,000 basic subscribers between the end of 1993 and March 31, 1994;  Adelphia Communications Corporation ("Adelphia"), which reported that it had 1.37 million basic subscribers at the end of the second quarter of 1994, up 8.4% from the same time in 1993;  Cablevision Systems Corporation ("Cablevision"), which recently reported that the average number of subscribers it served in each of the first two quarters of 1994 was 9% greater than the average for the corresponding quarters of 1993;  Viacom Cable ("Viacom"), which reported that it "added 6,500 incremental basic customers in the second quarter of 1994, approximately 266% over the amount added in the second quarter of 1993," and that since June 30, 1993, its subscribers have grown 3%, to 1,117,000;  E.W. Scripps Company ("E.W. Scripps"), which reported that as of the end of the second quarter of 1994, it had 715,700 basic subscribers, up 5.1% from the prior year, and that its penetration rate increased from 59.9% to 61.9% in the same period;  various cable system partnerships managed by Jones Intercable, Inc. ("Jones Intercable"), which reported basic subscriber growth in the twelve months ended June 30, 1994, most in the 5-6% range;  Cablevision Industries Corporation ("CVI") reported that it now serves 977,000 subscribers, and added 35,000 basic subscribers in the past year from internal growth of systems, in spite of the Los Angeles earthquake in January, which resulted in a loss of 5000 subscribers;  Century Communications Corporation ("Century"), whose recent annual report states that the number of subscribers it serves increased 2.4% from 919,000 on May 31, 1993, to 941,200 on May 31, 1994; and  Times Mirror Company ("Times Mirror"), which stated in its last quarterly report that specifically discussed its cable television operations that it experienced 3% internal basic subscriber growth between March 1993 and March 1994. 30. Revenues. Information from cable system operators that make financial information publicly-available through the SEC indicates that cable systems revenues have remained relatively steady through the first six months of 1994. According to the most recent annual or quarterly reports of fifteen cable system operators, ten reported increased cable system revenues and five reported decreases. For example:  TCI reported an overall 4% revenue increase for the first half of 1994, compared to the corresponding six-month period in 1993. According to its second quarter report, the increase in revenue that resulted from an increased number of subscribers exceeded the decrease in revenue that resulted from rate regulation;  Time Warner Cable ("Time Warner") reported slightly increased revenues for the first six months of 1994, stating that, "the unfavorable effects of rate regulation were offset in part by an increase in subscribers and unregulated revenues;"  Cablevision reported a 13% increase in its net revenues for the first six months of 1994, compared to 1993, most of which it attributed to a nine-percent internal growth in its number of basic subscribers; and  Adelphia reported that "[r]evenues increased approximately 5.5% for the three months ended June 30, 1994, compared to the same period in the prior year. Approximately 86% of such increases were attributable to basic subscriber growth, with the remainder primarily attributable to the expansion of advertising sales and other services." CVI, Century, Falcon Classic, Multimedia, TCA and Times Mirror also reported increased revenues. 31. On the other hand, several MSOs reported decreases in revenues during the first six months of 1994. Comcast's service income for its cable division was down nearly $24 million in the first half of 1994, as compared to the first half of 1993. E.W. Scripps reported that its revenues from basic service in the second quarter of 1994 were down 6.3% from the same period of 1993, despite a 5.1% increase in basic subscribers. Viacom's cable revenues decreased 4% in the second quarter of 1994, including $6 million in revenue losses from the mandated rate decreases. Falcon Cable and The Washington Post Company each reported cable revenue decreases of approximately 1%. 32. Capital Investment. The cable industry also appears to be substantially increasing its capital investment in infrastructure development. Kagan projects that the industry will invest nearly $3.8 billion in construction this year, which is a twenty-eight percent increase over the amount invested in construction in 1993. TCI alone has a capital budget of $1 billion for 1994 "for the continued rebuilding of its cable systems." 33. In February, Multimedia announced a $150 million upgrade of its cable operations over the next five years, which will include spending $45 million in both 1994 and 1995 to replace coaxial wire with fiber. Century increased its budget for capital expenditures in its cable operations by twenty-three percent over fiscal year 1993, from approximately $37.4 million to $46.1 million. Century plans to "expand the operations of certain cable television systems into adjacent and previously unbuilt areas," as well as to upgrade its existing cable plant. CVI's most recent quarterly report stated that the company plans to spend $68 million in 1994 for purposes such as expanding channel capacity, deploying fiber optic technology, and increasing the number of addressable converters. 34. Time Warner has reported that it will spend $750 million this year on cable capital investment, more than twice its 1993 cable capital outlays of $353 million. Time Warner also reported earlier this year, however, that the $750 million represented a reduction of $100 million from the amount that had been budgeted for 1994, due to rate reductions mandated by the Commission. E.W. Scripps spent 40.8% less on cable capital expenditures in the second quarter of 1994, and 30.7% less in the first half of 1994, as compared to the same periods in 1993, even though it now serves 5.1% more subscribers than in 1993. 35. Leading suppliers of cable hardware have reported substantial increases in sales this year. In particular, General Instrument Corp. ("GI") reports that its sales are up by over 64% for the first half of this year, and that its second quarter sales were 24% higher than its first quarter sales. Moreover, recent reports indicate GI's production of cable converter boxes has doubled from 9000 to 18,000 units per day, and GI is reported to attribute its increased sales to "increased cable television operator infrastructure spending . . . ." 36. Cable System Transactions. There has been considerable activity in the market for cable system transactions during 1994. The thirty-eight transactions announced in 1994 that have been identified by the Commission have a total dollar value of nearly $10.95 billion which, if the transactions are consummated, would be significantly greater than the $8.32 billion that changed hands in 1993. However, the average price of $2035 per subscriber and cash flow multiple of 10.2 times cash flow are somewhat lower this year than the 1993 levels of $2160 per subscriber and 11.3 times cash flow. Among the major proposed transactions that have been announced in 1994, are the following transactions involving four of the five largest MSOs:  the proposed acquisition by Comcast Cable of systems that Rogers Communications purchased from Maclean Hunter. The Rogers systems that are being purchased serve a total of 547,000 subscribers, and are being purchased for $1.27 billion;  the proposed acquisition by Cox Cable Communications of cable systems owned by Times Mirror serving 1.2 million subscribers, for a purchase price of $2.29 billion;  the proposed acquisition by TCI of systems owned by Tele-Cable Corp. serving 740,000 subscribers, for a purchase price of $1.5 billion; and  the proposed merger of certain cable systems owned by Time Warner, which serve 2.8 million subscribers, into a joint venture with cable systems owned by Newhouse Broadcasting Corp. and Advanced Publications, Inc., which serve 1.4 million subscribers. The cable systems being contributed to the proposed joint venture have been valued at $8.4 billion. III. STATUS OF EXISTING AND POTENTIAL COMPETITORS TO FRANCHISED CABLE SYSTEMS A. Market Definition 37. In this section of the Report, the Commission first discusses the relevant market concept and how it has been applied to the cable television industry by the Commission and Congress over time. Parts B and C of this section contain discussions of various other distribution media that offer, or could offer, services that, to different degrees, may have the potential to constrain cable industry conduct. 1. The Relevant Market Concept 38. Defining the "relevant market," a concept drawn from antitrust law, is an important first step in assessing whether a firm has market power, i.e., "the power to control market prices and exclude competition." The relevant market has both geographic and product components, which, when defined, allow for the identification of market participants and their respective market shares. 39. For the purposes of this Report, the Commission draws upon the relevant market concept in order to identify those distribution technologies that will potentially have a constraining effect on cable operator conduct. Therefore, as part of this and future reports, the Commission will report on the basic conditions relative to those industries, including the extent of their competition with cable operators. 40. Antitrust case law and economic theory define the relevant product market by analyzing the degree to which products or services are "reasonably interchangeable by consumers for the same purposes." The geographic market is defined in a similar manner. The geographic market is the area in which products compete with substantial parity. As with the definition of the relevant product market, its scope is defined by the geographic area to which buyers can reasonably turn or from which competing suppliers are likely to sell. 2. The Commission's Evolving Approach to Market Definition for Cable Services 41. In the mid-1980s, the Commission's view of the relevant market was shaped by its implementation of the 1984 Cable Act, which exempted cable systems from rate regulation unless the cable system was not subject to "effective competition" under a definition to be determined by the Commission. In 1985, the Commission adopted rules that deemed "effective competition" to exist if at least three unduplicated broadcast television signals were "available" to the cable community. The Commission thus concluded that three broadcast stations were sufficient to constrain monopolistic pricing of basic cable services, and defined a relevant market that included (though was not necessarily limited to) those two media. 42. The Commission's view of the relevant market in which cable operators compete has evolved considerably since the 1985 Effective Competition Report & Order. The Commission initiated a rulemaking in 1990 regarding the effective competition standard it had adopted five years earlier, and later issued the 1990 Cable Report. In the 1990 Cable Report, the Commission examined the services cable systems provided to consumers in a detailed manner. The Commission concluded that cable systems provide four distinct services: "antenna service" (retransmission of broadcast signals), "premium" programming (e.g., HBO, Cinemax), "general interest basic channels similar to independent television stations" (e.g., USA, TNT), and "specialized basic services" (e.g., ESPN, CNN, MTV, BET). Examining the "substitutability" of other media for each of these services, the Commission found that video cassette recorders ("VCRs") and video cassettes were good substitutes for premium services, and that local broadcast stations were good substitutes for the "antenna service." The Commission then proceeded to find evidence of market power in the remaining services. 43. The Commission recognized in the 1990 Cable Report that broadcasters offer some competition to cable systems, and "can be a significant constraint on basic cable rates." The Commission found, however, that "there is no close substitute for that steadily-expanding complement of specialized program services offered by the typical cable system at this time." The Commission also expressly rejected defining the market as "information and leisure entertainment services" (which would include radio, print media, movie, legitimate theater and live events as alternatives). As to the geographic market, the Commission concluded that the relevant market was essentially local in scope, noting that "because most cable systems operate under a local franchise, that describes the area within which they are entitled to distribute video services." 44. In a concurrent rulemaking proceeding, the Commission reexamined the "three over-the-air signals" test for effective competition adopted in 1985. When it sought comments in that proceeding, the Commission stated that it had replicated its prior research (which concluded that three-over-the-air broadcast signals could constrain basic cable rates), and found that its conclusions were no longer applicable to consumer demand in 1990. The Commission noted that "a small number of broadcast signals alone generally cannot deliver comparable service" to basic cable. On the other hand, in the 1991 Effective Competition Report & Order, the Commission found that if enough signals were available, broadcast television could have some constraining effect on basic cable pricing. Utilizing new econometric data, the Commission determined that six unduplicated over-the-air broadcast television stations were needed to constrain monopolistic pricing or conduct in basic services. 45. In 1991, the Commission also adopted a "multichannel competitor test" that recognized competition from alternative suppliers of delivered multichannel video services by creating a "50/10" test (50% availability of alternative sources with 10% total subscribership to those alternative sources). The Commission reasoned that even though alternative suppliers might offer different channel packages, "these alternatives should be considered substitutes for basic cable service since they provide a variety of programming services . . . ." 3. The 1992 Cable Act 46. The 1992 Cable Act, in part, uses a conceptual view of the relevant market similar to that outlined in the 1990 Cable Report to define the circumstances when cable rates will be exempt from rate regulation. It provides that a cable system will be subject to rate regulation unless the cable system is subject to "effective competition," a determination which is to be made through the use of a two-part test. 47. First, the 1992 Cable Act identifies the types of services that are capable of constraining cable system pricing. Each such service is referred to as a "multichannel video programming distributor" ("MVPD"), and is defined as "a person . . . who makes available for purchase, by subscribers or customers, multiple channels of video programming." Thus, the 1992 Cable Act explicitly contemplates a relevant product market comprised of distributors that offer multichannel video programming on a subscription basis. 48. Second, the 1992 Cable Act requires determination, on a franchise-area by franchise-area basis, of when "effective competition" is deemed to exist by reference to the actual presence of MVPDs providing service in a particular locale. Specifically, effective competition exists under the 1992 Act where the franchise area is served by at least two MVPDs, each of which "offers comparable video programming" to at least 50% of the households, and at least 15% of the households "subscrib[e]" to the smaller MVPD. The 1992 Act provides for consideration of only those firms that have actually entered the market and are providing service in determining whether cable rates in a particular franchise area should be deregulated. The 1992 Act also contains a penetration test, whereby effective competition is deemed to exist if "fewer than 30 percent of the households in the franchise area subscribe to cable service of the cable system." In addition, effective competition is deemed to exist if a municipal cable system offers service to at least fifty percent of the households in the franchise area. 4. Implications of Market Definition for This and Future Reports 49. Product Market. For purposes of this Report, the relevant product market contemplated in the 1992 Act -- multichannel video programming service -- is the appropriate starting point for assessing the status of competition in the market for the delivery of video programming. A primary focus of this Report, and a central concern of the 1992 Cable Act, is the extent to which MVPDs that use alternative technologies are emerging as significant competitors to cable operators. In addition to cable operators (which include direct competitors known as "overbuilders"), MMDS, DBS, and TVRO providers are specifically included within the statutory definition of an MVPD, and the Commission has subsequently determined that VDT and SMATV systems should be considered MVPDs, as well. Consequently, this Report will evaluate the status of providers utilizing each of these technologies. 50. In addition, the Commission will discuss other video programming distribution media as potential substitutes for cable services. While the use of current broadcast technology is expressly excluded from the statutory definition of an MVPD (because a broadcast station does not offer "multiple" channels of video programming and is not offered on a subscription basis), the Commission nonetheless includes a discussion of broadcast television in this Report, given broadcasting's potential constraining effect on cable industry conduct. Finally, the Commission discusses in this section other delivery media that arguably may have a competitive impact in the market, including low power television, programming distribution by electric utilities and VCRs. 51. Geographic Market. The proper definition of the geographic market in which cable operators compete has relevance both to the assessment of cable operators' market power, and to the administration of the "effective competition" standard of the 1992 Act, a topic which will be addressed in future reports. As discussed above, the scope of the geographic market is defined by the geographic area to which buyers will reasonably turn and from which competing suppliers sell their products. Given the current state of competitive entry, it would seem reasonable to define, at least tentatively, the local franchise area as the geographic market relevant to an analysis of the cable industry. 52. On the other hand, it is not entirely clear that cable operators view the franchise area as the "area of effective competition." While at the system level, competition may be viewed on a franchise by franchise basis, MSO operations at the firm level may be national in scope, and are often comprised of a series of regional clusters. 53. Moreover, over time, it is likely that consumers will be able to purchase services from MVPDs located outside their franchise areas. For example, wireless cable and SMATV systems may serve entire metropolitan areas. A LEC providing VDT service may serve an entire region of the country. Finally, DBS service providers may contemplate a national market. Therefore, as competitive entry increases, the definition of the geographic market for purposes of economic analysis may be broadened beyond the franchise area to account for the impact of these alternative suppliers. B. The Status of Existing Competitors to Franchised Cable Systems 1. Overbuilders 54. The term "overbuild" describes the situation in which a second cable operator enters a local market in direct competition with an incumbent cable operator. In these markets, the second operator, or "overbuilder," lays wires in the same area as the incumbent, "overbuilding" the incumbent's plant, thereby giving consumers a choice between cable service providers. 55. In the 1990 Cable Report, the Commission found that the number of overbuilders was "relatively small," noting reports of forty to forty-nine directly competitive systems in operation at the time of that Report. The Commission found, however, that "direct competition has resulted in reduced per channel rates for cable service." Therefore, in order to stimulate further competition from cable overbuilders, the 1990 Cable Reportcontained the recommendation that Congress: "(a) forbid local franchise authorities from unreasonably denying a franchise to potential competitors who are ready and able to provide service; (b) prohibit franchising rules whose intent or effect is to create unreasonable barriers to the entry of potential competing multichannel video providers; (c) limit local franchising requirements to appropriate governmental interests (e.g., public health and safety, repair and good condition of public rights-of-way, and the posting of an appropriate construction bond); and (d) permit competitors to enter a market pursuant to an initial, time-limited suspension of any 'universal service' obligation." 56. Congress incorporated the Commission's recommendations in the 1992 Cable Act by amending  621(a)(1) of the Communications Act to provide that: [a franchising authority may award . . . 1 or more franchises within its jurisdiction]; except that a franchising authority may not grant an exclusive franchise and may not unreasonably refuse to award an additional competitive franchise. Any applicant whose application for a second franchise has been denied by a final decision of the franchising authority may appeal such final decision pursuant to the provisions of section 635 for failure to comply with this subsection. In addition, Congress amended the Communications Act to require a franchising authority to "allow the applicant's cable system a reasonable period of time to become capable of providing cable service to all households in the franchise area." 57. In connection with its March 30, 1994 Report and Order regarding rate regulation, the Commission examined the competitive differential between markets that were overbuilt and those that were not. That competitive differential was defined as the difference in monthly average revenue per subscriber between two cable systems, otherwise identical, one of which is subject to duopolistic competition from the overbuilder, and one of which is not. The Commission's statistical analysis refined the measure of the strength of overbuild competition by taking account of the amount of overlap between competing providers. Under that analysis, the Commission determined that the rates in markets that were overbuilt were an average of sixteen percent lower than the rates in markets that were not overbuilt. 58. Several economic studies of direct competition in the cable industry also show that competition from overbuilding lowers cable rates. Anecdotal evidence shows positive service and rate effects from overbuilds. For example, in Glasgow, Kentucky, consumers can choose between two cable systems -- one of which is operated by the Glasgow Electric Plant Board ("GEPB"), the municipal electric utility. In anticipation of overbuild entry by GEPB in June 1989, the incumbent operator initially dropped its basic rate for twenty-four channel service from $23.00 to $5.95. As of September 1993, after more than four years of direct competition, the municipal operator entrant offered forty-eight channels for $13.50 a month; the incumbent charged $8.95 for thirty-seven channels. 59. In a 1990 article, Thomas Hazlett reported on four instances of 1987 overbuild entry, three of which were in Florida. In Orange County, an overbuilder secured a county- wide franchise permitting competition in all unincorporated areas. In response, two different incumbents each reduced their basic prices by half, from the $13.00-per-month range to the $6.50-per-month range. In Riviera Beach, the incumbent operator responded to the entry of an overbuilder in 1987 by expanding its twelve-channel basic service priced at $8.40 to a package competitive with the overbuilder's twenty-six-channel, $5.75 offering. In Dade County, Florida, the incumbent operator reduced its basic service price by one-third to match a new overbuild entrant. Finally, an overbuilder entering the market in Sacramento, California in late 1987 offered thirty-six to forty-two channels at $10.00 a month, and a $10.00 installation charge, compared with the incumbent's forty-channel, $14.50 offering. However, while the incumbent initially repriced to meet the entrant's prices, it purchased the competitor six months later. 60. While most studies suggest that overbuilding produces meaningful rate effects, the extent of overbuilding seems to have remained quite limited, despite the 1992 Cable Act's explicit purpose to encourage the emergence of direct competition. The Commission is aware of only a few new overbuilding proposals. One example is that of FiberVision Corporation, which has plans for several significant overbuilds in Hartford, Bridgeport, New Britain and New Haven, Connecticut. In has also been reported that local authorities in Greenburgh, New York are considering allowing Northeast Networks, Inc., to overbuild and compete with the incumbent, TCI of Westchester, and have agreed to let Liberty Cable Company, Inc. provide cable service via fiber optic lines of NYNEX, the local exchange carrier. According to one report, Liberty Cable will initially provide service to two condominium complexes, and may then expand its service to additional complexes and single family homes. Finally, recent press reports indicate that Cablevision, currently the nation's fifth largest MSO, is considering overbuilding several systems in New Jersey. The Commission will track the progress of existing overbuilds and monitor the emergence of new overbuild construction on an on-going basis. 2. Direct-To-Home Satellite Services 61. Two distinct types of direct-to-home ("DTH") satellite services now offer video programming for subscription that is comparable to the satellite-delivered programming provided by cable television services. DBS is one. Technically, DBS service refers to satellites that transmit signals "intended for reception by the general public" operating pursuant to Part 100 of the Commission's Rules in a portion of the Ku-band. At present, the only operational DBS service, as that term is defined in the Commission's rules, is the high-power Ku-band DBS service offered by Hughes Communications Galaxy, Inc./DirecTV ("DirecTV") and United States Satellite Broadcasting ("USSB"). Another service, the medium-power Ku-band service offered by Primestar Partners, L.P. ("Primestar"), is commonly referred to as "medium power DBS," although the service operates in the Fixed Satellite Service ("FSS"). The second type of DTH service is offered by the home satellite dish (HSD) industry, and involves the home reception of signals transmitted by satellites operating generally in the C- band. a. Direct Broadcast Satellite (DBS) 62. In 1982, the Commission authorized DBS service, and granted the first of several construction permits. Even though DBS service was not yet operational at the time, the Commission found in the 1990 Cable Report that the medium had the potential to "readily compete with cable," provided that adequate programming was available. 63. Since 1990, DBS has advanced as a potential long-term viable competitor to cable. In December, 1993, the first high-power DBS satellite ("DBS-1"), owned by DirecTV and operated jointly with USSB, was launched. DirecTV owns eleven transponders on DBS-1, and USSB owns the other five. On June 17, 1994, DirecTV and USSB began providing high-power DBS service via DBS-1, and DirecTV currently is transmitting over fifty channels of subscription and pay-per-view programming. On August 3, 1994, DBS-2, also owned by DirecTV, was launched; DirecTV owns all sixteen of the transponders on DBS-2. When DBS-2 becomes operational, which is projected to occur on September 19, 1994, DirecTV's digital broadcast facility will purportedly be able to process and transmit as many as 216 video and audio channels simultaneously. 64. DirecTV states that it will be able to increase channel capacity by increasing power and introducing a new signal compression standard, which will allow it to provide an additional fifteen to twenty channels by 1995. DirecTV has also filed an application to operate a third satellite, which is scheduled to be launched in early 1995. USSB, with five transponders, currently offers twenty channels, and stated in comments in this docket that improvements in encoder equipment and software will make it possible to expand its service to offer twenty-five to twenty-eight channels over the next few months. 65. As of September 9, 1994, DBS equipment was available in twenty-three states, and approximately 40,000 households were receiving programming via DBS. DirecTV expects that DBS equipment will be available throughout the continental United States by early November 1994. Subscribers receive video programming directly from the satellite through small reception dishes that are approximately eighteen inches in diameter. The home receiving equipment that is required to receive the service costs $699, and subscribers can either pay $150-200 for professional installation or purchase the installation equipment for $69.95. The $699 Digital Satellite System ("DSS") unit allows a subscribing household to watch one channel at a time. In order to view two different channels on different television sets, a person must purchase an $899 DSS unit and then also purchase a $649 decoder for the second television set. Thomson Consumer Electronics ("Thomson"), under the brand name RCA, produces the DSS equipment which includes the receiving dish, digital receiver and remote control. Thomson/RCA has an exclusive contract to produce DSS units for the first eighteen months or one million units, whichever occurs first. After that, Sony and Thomson will both produce the DSS equipment for the next six months. Thereafter, other manufacturers may be licensed to produce DSS equipment. 66. DirecTV states that despite the relatively significant initial cost, 400,000 to 500,000 DSS units will be shipped by Thomson/RCA this year, and that equipment costs will decline over time. Retailers in the first five markets in which DBS service has been introduced have reported that the demand for the dishes has exceeded the supply. By the end of 1994, according to USSB, approximately 10,000 locations nationwide will be carrying DSS equipment and offering both USSB and DirecTV programming. As part of its marketing effort, Hughes has also entered into an agreement with the National Rural Telecommunications Cooperative ("NRTC") to provide DirecTV services to subscribers through its membership across the country. 67. In addition to DirecTV and USSB, several other ventures are attempting to enter the high-power DBS field. EchoStar Communications Corporation ("EchoStar"), which has reportedly raised $332 million dollars in a debt offering, is required by the terms of its construction permit to have its system in operation by August 15, 1995. Directsat Corporation and Direct Broadcast Satellite Corporation, which are each authorized to provide eleven channels of service, are required by their construction permits to be operational by August 15, 1995. Tempo Satellite, Inc. (a wholly-owned subsidiary of TCI), is authorized to provide eleven channels of service and is required to be operational by May 1, 1998. The other parties, which have received conditional construction permits, but have not yet been assigned specific orbital positions and channels, are Continental Satellite Corporation, and Dominion Video Satellite, Inc. According to the terms of its construction permit, Continental's DBS system is to be operational by December 4, 1996. Finally, Advanced Communications Corporation, which has been assigned orbital positions and channels, is required to have its system operational by December, 1994. 68. In addition to the high-power DBS services listed above, Primestar is a joint venture owned by six MSOs, and GE American Communications, Inc., which owns the satellite used by Primestar. Primestar has been operational as a medium-power Ku-band service provider since 1991, and its service is available to consumers using thirty-six-inch and forty-inch dishes. As of June 4, 1994, Primestar served 70,383 subscribers, and it began to use digital technology to provide service to its subscribers by digital technology on July 31, 1994. Primestar is currently conducting a $55 million advertising campaign, and now offers seventy-one video channels. Ultimately, after it makes a planned transition to a new generation of satellites in 1996, Primestar plans to offer more than 150 channels of programming. 69. By its very nature, DBS is a national video programming distribution service. DirecTV considers its potential subscriber base to be all 94 million television households. However, DBS service does not offer local broadcast signals, a fact which some commenters argue inhibits the ability of DBS service to become an effective competitor to cable service. On the other hand, DBS service might provide consumers with service attributes that are not generally available on cable systems at this time. For example, USSB states that DBS subscribers will have digital video and compact disc ("CD") quality sound, and DirecTV states that its DBS system, which has a modem in the DSS receiver, will have interactive capabilities via telephone lines. 70. DBS service providers and equipment manufacturers are highly optimistic about the potential for subscribership growth. USSB predicts that between one and two million dishes will be sold within a year, and five to ten million will be sold within three years. DirecTV projects that it will have over three million subscribing households within three years. USSB estimates that in seven years, almost forty percent of all television households may receive programming via DSS equipment. Thomson Consumer Electronics/RCA, the current manufacturer of the DBS dishes, anticipates sales of ten million units in the next six years. Finally, although Primestar has concentrated its early efforts on areas unserved by cable or wireless cable, it projects that it will serve in excess of 200,000 subscribers by the end of 1994, and two-to-five million by the end of the decade. b. Home Satellite Dishes (HSDs) 71. HSD technology was first developed in 1976, and commercialized in 1980. HSDs are approximately 7-10 feet in diameter and receive video programming transmitted in the C-band of frequencies. HSD owners can watch without payment approximately 150 unscrambled signals, and another 103 scrambled channels can be ordered through program packagers. Generally, HSD owners have access to the same programming services that are available on cable, although the most popular cable programming services are scrambled. In order to receive one or more scrambled channels, an HSD owner must purchase an integrated receiver-decoder ("IRD") from an equipment dealer and then pay a monthly or annual subscription fee to one of the thirty or so national packagers of HSD programming. 72. In the 1990 Cable Report, the Commission observed that HSD use in the United States had grown to roughly 2.8 million units from approximately 900,000 in 1984, and that this growth stalled in 1986 with the advent of satellite signal scrambling. In addition, the Report noted that zoning regulations could restrict many viewers' ability to install an HSD system. 73. Today, there are approximately four million HSD users, roughly half of whom, according to SBCA estimates, subscribe to one or more programming services. It has also been reported that almost all recent buyers of HSD systems are choosing to subscribe to a programming service. Consumers pay an average of $2,500 for a complete HSD system, although one commenter states that a C-band system can be purchased and installed for as little as $1,000. There are indications that HSD use might be increasing -- SBCA reports that 55,000 C-band systems were shipped in April 1994 and another 61,000 were shipped in May 1994. Those are the two highest monthly totals of C-band shipments since 1986, the year programmers began scrambling their signals. 74. A survey by the SBCA indicates that HSDs and cable systems may be either complementary video programming services or substitutes for each other, depending on viewer preferences and other circumstances. That survey found that 61% of HSD systems were purchased by persons who did not have access to cable at the time they purchased the HSD. However, the survey also found that 37% of HSD owners with access to cable subscribe to cable services, and that 18% of HSD owners who subscribe to satellite-programming packages also subscribe to cable. Among HSD owners who subscribe to both cable and one or more satellite-programming packages, 41% did so for the purpose of receiving local television stations. 75. The HSD industry's primary competitive strength vis-a-vis cable is programming variety and flexibility. An HSD owner may choose from a variety of program packages offered by the approximately thirty program packagers nationwide. Those program packagers compete with each other to offer owners the most desirable combinations of programming services at attractive prices. One commenter states that the average HSD subscriber purchases programming from 2.5 different outlets. The survey commissioned by the SBCA found that the most common reason for purchasing an HSD was to gain access to an increased variety of programming. 76. Although HSD services offer more programming options than any other video delivery system, the cost of a system entails a large upfront expenditure by the consumer. Another drawback for HSD services comes from the fact that many localities have enacted zoning ordinances that restrict the deployment of HSDs. Although the Commission has preempted zoning ordinances that either discriminate against HSDs without "a reasonable and clearly defined health, safety or aesthetic objective," or impose "unreasonable limitations" on the use of satellite dishes, the SBCA reports that local authorities continue to enact ordinances that violate these rules. It also notes that the Commission's ability to enforce its zoning preemption rules recently has been limited by a federal court decision. Therefore, the SBCA requests that the Commission clarify its rules preempting zoning ordinances that unreasonably differentiate between satellite dishes and other types of antennas. Related to the zoning problem is the SBCA's contention that homeowners' associations, through covenants and other restrictions, prohibit homeowners from deploying HSDs. Although the SBCA estimates that eighty percent of all new homes in the United States are part of homeowners' associations, there is no indication of how widespread this practice may be. 77. A third factor that may affect the ability of HSD systems to compete with cable systems is presented by claims that HSD program packagers are charged prices for video programming that cannot be justified under the Commission's program access rules. Those claims are addressed in the Commission's discussion of the program access rules in Section IV.B.2.a of the Report. 3. Terrestrial "Wireless" Cable -- Multichannel Multipoint Distribution Service (MMDS) 78. The term "wireless cable" refers to the Multipoint Distribution Service ("MDS") and MMDS (Multichannel Multipoint Distribution Service), both of which transmit video programming using over-the-air microwave radio channels. Subscribers use rooftop antennas to receive the programming transmitted from the wireless cable tower. The signals received are then sent through electronics equipment to the subscriber's television set. There are eleven MMDS channels available to wireless cable system operators for full-time use, and either two or three single-channel MDS channels depending on the particular city. In addition, wireless cable system operators have access to the twenty channels allocated to Instructional Television Fixed Service ("ITFS") on a leased, part-time basis. Thus, wireless cable operators have access to a maximum of thirty-two or thirty-three channels. 79. The wireless cable industry has increased its subscribership from 50 systems serving 300,000 subscribers in 1990, to 143 systems serving 550,000 subscribers by June 1994. In addition, analysts have projected the number of wireless cable subscribers to grow through the end of the decade. Although wireless cable has not achieved significant penetration nationwide, there are a number of markets in which wireless cable has gained a foothold in competition with wired cable systems. In Riverside, California for example, Cross Country Wireless Cable TV has attracted 42,000 subscribers out of a total of 400,000 homes that can receive its services. People's Choice TV in Tucson, Arizona had 22,000 subscribers as of June 1994, and projects that it will add another 18,000 subscribers over the next two years. CableMaxx currently has 14,000 subscribers in Austin, Texas and is adding subscribers at the rate of 1000 per month. ACS Enterprises, which operates in the Philadelphia, Pennsylvania area, has approximately 30,000 subscribers. Finally, after just over two years of operation, Coastal Wireless Cable Television provides service to 10.5% of the homes in Ft. Pierce, Florida that are capable of receiving its signal. 80. Wireless cable operators recently have gained access to financing from public debt and equity markets. Since December 1992, wireless operators have raised almost $600 million from the public markets. Those funds permit wireless operators to acquire multiple systems, and thereby to begin laying the foundation for the economies of scale now enjoyed by MSOs. Access to public financing also permits wireless operators to expand their systems more rapidly. For example, after People's Choice TV issued stock to the public on July 8, 1993, it increased its subscriber base in Tucson, Arizona from 13,000 to 22,000, and now expects to add a total of 125,000 subscribers to its five systems by March, 1995. Accordingly, it appears that access to public financing, as well as increasing credibility with banks, may have helped to alleviate one of the major problems that has confronted the wireless industry. 81. The wireless cable industry has a number of strengths vis-a-vis cable. First, wireless cable system operators appear to incur lower costs for the initial construction of their systems. One analyst estimates that wireless cable systems have capital costs that are one- third lower than the capital costs of cable systems. The lower initial construction cost allows wireless operators to provide comparable service at lower prices than cable. Indeed, it has been argued that those lower prices are the basis for the growth of wireless cable up to this point. 82. Second, it appears wireless operators may be able to upgrade their systems to employ digital compression and interactive applications at a lower cost per subscriber than cable system operators. A study undertaken by People's Choice TV estimated that upgrading to digital compression and interactive applications would cost cable operators almost twice as much as wireless operators. 83. Third, in contrast to cable system operators, wireless cable operators are not required to obtain franchises in order to provide service. However, at least one state now regulates various aspects of the customer service provided by wireless cable operators and other MVPDs. 84. Finally, wireless systems may have technological advantages. Because radio frequencies rather than wires are used to deliver signals to subscribers, it has been suggested that there is both less signal degradation, which results in higher picture quality, and fewer outages than with cable systems. 85. However, WCA has pointed to several remaining obstacles which it claims could hamper the growth of wireless cable. First, wireless cable operators have difficulty in gaining access to a sufficient number of channels to provide a competitive service. As previously noted, wireless cable operators may assemble a maximum of thirty-three channels to transmit programming in any one market. Moreover, while some operators have accumulated thirty or more channels, others have encountered difficulty in obtaining licenses. That difficulty results in part from the opportunities for "warehousing" of licenses that both the MMDS and ITFS licensing methods have presented. 86. In order to bring the application process under control, and to prevent further speculative filings, the Commission instituted application freezes both for new MDS stations, and for new ITFS stations or major modifications to ITFS applications or facilities. WCA states that these application freezes, along with extensive use of ITFS channels by educational institutions in certain markets, have slowed the accumulation of channels by wireless operators. On June 9, 1994, the Commission undertook several steps aimed at eliminating regulatory delays for wireless cable licensing, one of which was to lift the application freeze for major modifications to ITFS licenses. The WCA believes that the Commission's substantive and administrative improvements in wireless cable licensing will improve the Commission's ability to process the pending legal and application backlogs. 87. Second, wireless cable transmitters must have line-of-sight access to a home in order for that home to be capable of receiving wireless cable service. Consequently, many homes are unable to receive service from this technology because they are blocked by trees or buildings. It has been estimated by one analyst that the average wireless cable operator has line-of-sight access to seventy-five percent of the homes in its service area. That percentage varies depending on the strength of the wireless cable transmitter and the topography of the service area. WCA reports that a low-cost signal booster, which allows homes without line-of- sight to receive service, recently has been developed. If effective, this technology would increase the number of "homes seen" by wireless systems. It is unclear, however, whether signal boosting can be accomplished in most wireless systems on a cost-effective basis. 88. Third, wireless operators complain that their operations are hampered by the fact that they cannot interconnect separately-owned buildings by wire, even if the wire only crosses private property. WCA states that the interconnection of subdivisions, townhomes and trailer parks by wire is more efficient than interconnection by microwave, which requires the purchase of expensive equipment. Accordingly, WCA contends that Congress's failure to extend the "private cable" exemption of the Communications Act to interconnection of separately-owned buildings on private property is "one of the greatest impediments to competition." 89. Finally, WCA has suggested that a potential impediment to the growth of wireless cable services is alleged anticompetitive behavior by cable operators. For example, WCA described situations in which franchised cable operators may have induced local ITFS licensees to not lease their excess capacities to wireless cable operators. The record does not contain the necessary evidence to determine how widespread those allegedly anticompetitive practices might be. However, to the extent that aggrieved parties believe that such conduct violates Commission rules, their concerns may more properly be addressed in an appropriate complaint before the Commission, rather than in this Report. 90. Overall, it appears that two of the wireless cable industry's most significant problems, lack of capital and insufficient channel capacity, are being addressed. First, the program access provisions of the 1992 Cable Act appear to have given wireless operators the credibility to raise money in the public debt and equity markets, thereby easing the financial difficulties experienced by many wireless systems. Second, the combination of improved Commission licensing and the use of digital compression is expected to alleviate wireless cable's channel capacity problem in the near future. The progress in these two areas has led some analysts to forecast continued growth for this industry. One industry analyst predicts that the wireless industry will serve 800,000 subscribers by the end of 1994, and 3.2 million subscribers by the year 2000. That report also contained an estimate that the subscriber total will be drawn from approximately thirty-seven million homes capable of receiving wireless cable, which would mean that wireless cable services would be subscribed to by 8.7% of the households to which it is available. 4. Satellite Master Antenna Television Systems (SMATV) 91. SMATV system operators (also known as "private cable systems") are MVPDs that serve residential, multiple-dwelling units ("MDUs"), and various other buildings and complexes. A SMATV system offers, in general, the same type of programming as a cable system, and the operation of a SMATV system, in large part, resembles that of a cable system -- a satellite dish receives the programming signals, equipment processes the signals, and wires distribute the programming to individual dwelling units. The primary difference between the two is that SMATV systems typically are unfranchised, stand-alone systems that serve a single building or complex, or a small number of buildings or complexes in relatively close proximity to each other. However, SMATV operators are increasingly using microwave facilities to interconnect properties spread over a metropolitan area. 92. Currently, one industry source estimates that there are approximately 3000 to 4000 SMATV systems operating nationwide. As of August 15, 1994, approximately one million subscribers were served by SMATV systems. It is projected that by the end of 1994 there will be approximately 1.03 million subscribers to SMATV systems in MDUs, and over 1.10 million such subscribers by the end of 1995. 93. Instances of SMATV service to MDUs and other buildings and complexes include the following:  Liberty Cable Corporation ("Liberty Cable") operates private cable systems in Manhattan, New York, competing head-to-head with the incumbent franchised cable systems operated by Time Warner. According to its comments, Liberty Cable serves approximately 20,000 subscribers, and currently is adding approximately 1000 new subscribers each month. Liberty Cable claims that it offers its services at approximately one-half the price of Time Warner. Liberty Cable also comments that it has expanded the scope of its operations through use of an 18 GHz microwave network, which links its facilities without the need to use public rights-of-way.  MSE Cable Systems, Inc. ("MSE") provides SMATV service to MDUs and mobile-home parks in Southeast Michigan. MSE reportedly has grown from four systems passing approximately 2000 homes to thirty systems passing approximately 16,000 homes. It is suggested that MSE began serving its mobile-home park subscribers at a time when no franchised cable operators offered service to those locations, and thus developed its business by filling the need for video programming service in those locations.  Cable Plus, headquartered in Bellevue, Washington, operates SMATV systems in nine states, mostly in the west. In five years, it has grown from 8 systems passing approximately 2500 homes, to approximately 200 systems passing approximately 50,000 homes.  OpTel, Inc. has been operating SMATV systems since November, 1993. OpTel provides SMATV service to more than 330 properties, passing more than 105,000 households and serving more than 41,000 subscribers, in the Los Angeles, San Diego, Houston, Phoenix and the Dallas-Ft. Worth metropolitan areas. OpTel reportedly makes extensive use of 18 GHz microwave links to connect the facilities it serves, and also uses other delivery technologies, including coaxial and fiber optic cable. It is reported that 25% of OpTel's customers receive at least fifty- four channels, and the company expects to upgrade most of its remaining systems to provide similar channel capacity.  MaxTel Cablevision has SMATV operations in twenty-five states. Originally formed as a subsidiary of a real estate development company, MaxTel now serves approximately 280 properties. Its systems pass nearly 85,000 households and have 42,000 subscribers. 94. SMATV operators may have the ability to offer lower prices than can wired cable operators for substantially the same services. Indeed, it is suggested that some SMATV operators may set their rates by looking to the rates charged by cable incumbents as guidelines and offering certain discounts from the cable rates. It has also been reported that SMATV systems charge lower rates than franchised cable operators for premium services, with such price differences ranging from $1.00 per channel to an overall sixty percent discount. One commenter suggests that SMATV operators are able to offer lower prices because cable systems are prohibited by Commission rules from engaging in price competition for a particular MDU where a SMATV system operates. 95. On the other hand, regulatory barriers may artificially raise the cost of operating SMATV systems. First, where a SMATV system uses wires to connect separately-owned buildings, even though no public rights-of-way are crossed, a SMATV system is considered to be a "cable system" under the Communications Act, thereby requiring the operator to obtain a local franchise. As is the case with wireless cable operators, the statutory definition of "cable system" may thus have the unintended effect of raising the costs of SMATV operators, thereby having a negative effect on competition. 96. Moreover, SMATV operators contend that cable operator conduct under the Commission's cable home wiring rules has a chilling effect on competition. Those rules, require, inter alia, that cable operators provide subscribers with the opportunity to acquire cable home wiring before the cable operator removes it from the premises after termination of service. One SMATV operator argues that under these rules, it is unable to connect a subscriber that switched from the cable operator's services until after the cable operator disconnects and removes its equipment. As a result, this SMATV operator contends that potential subscribers are dissuaded from switching to SMATV from their existing cable company. However, it is unclear from this record whether these types of concerns reflect anticompetitive abuses, which can be remedied by changing the Commission's home wiring rules, or merely reflect the competitive nature of the marketplace. The Commission will address home wiring issues when it rules on the petitions for reconsideration that are now pending. 5. Broadcast Television Service 97. Broadcast television stations are, and always have been, significant suppliers in the market for delivered video programming. In the 1993-94 season, ABC, CBS, NBC and Fox maintained a combined 72% share of prime-time viewers. Even among those households subscribing to cable, retransmitted broadcast channels had a 46% prime time viewing share in the 1992-93 season, while retransmitted independent broadcast and public television stations maintained 17% and 3% shares respectively. Therefore, two-thirds of all cable households watching television delivered by cable in the 1992-93 season were watching a retransmitted broadcast channel. Moreover, more than one-third of all households that could subscribe to cable service elected not to do so. Accordingly, it would appear that for at least some viewers, broadcast television service satisfies their demand for video programming. 98. Moreover, broadcast television remains an important outlet for the distribution of local news, public affairs, and sports programming. As the Commission found earlier this year, high profile sporting events like the Super Bowl, the World Series, the NBA Championships, and the NCAA basketball championships remain on broadcast television. 99. Finally, it has recently been reported that "[d]emand for television stations is at one of its highest levels in years." First-quarter 1994 profits of broadcast television station group owners rose by at least 30%, fueled by increased advertising revenues. In addition, Fox has successfully launched what has been termed an "emerging" fourth broadcast network, and it is widely reported that Time Warner and Paramount, companies with cable television affiliations, are also seeking to create broadcast networks. There are also more broadcast stations today than ten years ago, when the 1984 Act was passed. Between 1984 and 1994, the number of television stations operating in the United States grew from 1149 to 1518, which represents a 32% increase in the number of broadcast signals available to the public. 100. Despite the increases in broadcast television output noted above, the number of broadcasting outlets available to consumers has not kept pace with the virtual explosion of programming alternatives available on cable television. In the last decade, the number of national cable video networks increased from forty-seven to ninety-nine, an increase of 110%. The channel capacity of cable systems has also grown dramatically. Cable systems have responded successfully to consumer demand in the last decade, as the market penetration of the cable industry has increased from 43.7% in 1984, to 62.5% in 1994. 101. The Commission found in 1991, that the availability of over-the-air broadcast signals, can, under certain circumstances, have some constraining effect on cable system conduct. However, cable systems offer a "steadily-expanding complement of specialized program services," which can increasingly meet consumer demand for more video programming choices. Accordingly, any constraining effect appears to decrease to the point where the menu of available broadcast signals is insufficient to constrain cable market power. Most recently, the Commission examined the competitive effect of broadcast stations on cable rates in connection with the 1994 Rate Report & Order. There, the Commission's statistical analysis was consistent with a finding that the availability of six or more local broadcast stations does not constrain cable rates. 102. Advances in broadcast technology and regulatory policy might allow for multichannel broadcasting of digitally-compressed signals. The Commission has recognized that multiplexed, multichannel broadcast signals could provide a competitive check on the exercise of market power by cable systems in the future. In its 1993 Rate Report & Order, the Commission stated that "should digital compression or other technology advance to the point that a single broadcaster in a community were able to offer programming comparable to that offered by a cable system, such a broadcaster might well be deemed an MVPD effectively competing with the cable operator." The Commission reaffirms that possibility here. C. Other Actual or Potential Competitors 1. Local Exchange Carrier (LEC) Entry 103. As noted in the NOI, the participation of local exchange carriers ("local telephone companies" or "LECs") in the multichannel video marketplace was not included in the competition analysis of the 1990 Cable Report because it was deemed unlikely to occur in the near term. At that time, local telephone companies were prohibited by statute and federal regulation from providing video programming directly to subscribers within their service areas. While LECs were permitted to provide video programming outside their telephone service areas, and channel service to unaffiliated cable operators within their service areas, few LECs participated in such ventures. 104. Since 1990, the Commission has adopted orders easing the regulatory restrictions and creating a "video dialtone" ("VDT") framework for LEC participation in the multichannel video distribution marketplace consistent with the statutory prohibition. That VDT framework, along with technological advances, has spurred increased video-related activity by LECs, including several market and technical trials and twenty-four applications for permanent authority covering over 8.5 million homes. These applications, taken together, constitute a promising source of competition to cable operators for the multichannel distribution of video programming. 105. In this section of the Report, the Commission reviews: (1) the regulatory and statutory framework for LEC participation in the provision of video programming to subscribers; (2) the technology involved in deployment of a VDT system; (3) the status of the authorized market and technical trials; and (4) the applications for permanent VDT authorizations. The Commission also discusses the technology and architecture of the systems, and the regulatory and reporting issues that may affect the potential of this technology to provide competition to cable. 106. Regulatory Framework for LEC Participation in Video Transport Services. Under the VDT regulatory framework adopted by the Commission in 1992, a LEC may make available, on a nondiscriminatory common carrier basis, a platform capable of providing nondiscriminatory access to multiple video programmers and of delivering video programming and other services to end users within its local telephone service area. The LEC may also provide additional enhanced and non-common carrier services to customers of the common carrier platform. In fashioning the VDT scheme, the Commission determined that the statutory cross-ownership restriction applies only to LECs within their local exchange service areas, and not to interexchange carriers. In addition, neither a LEC offering VDT service, nor its programmer-customers, is required to obtain a local cable television franchise. A LEC may own up to five percent of a video programmer, and participate in certain non- ownership affiliations with video programmers that use the basic platform. Authorization pursuant to Section 214 of the Communications Act ("Section 214 authorization") is required for LEC provision of VDT service, and the Commission has established safeguards to prevent discrimination and cross-subsidization. 107. As noted above, a LEC may also participate in video transport service through the provision of traditional channel service within its telephone service area to unaffiliated cable systems. The VDT framework does not affect this traditional service offering. Consistent with the statutory restriction, a LEC is also permitted to own and operate cable facilities outside its service area, and to own video programming. 108. The Commission has recommended that Congress repeal the telephone company-cable company cross-ownership prohibition and permit LECs to provide video programming directly to subscribers within their service areas. The cross-ownership restriction was instituted by the Commission in 1970, following a series of proceedings in which the Commission found that telephone companies denied access or provided discriminatory access to cable systems to utility poles necessary for cable distribution. Certain aspects of the regulatory restriction were codified by Congress in the 1984 Cable Act. In 1993 the U.S. District Court for the Eastern District of Virginia held the cross- ownership prohibition unconstitutional as applied to Bell Atlantic in its service areas; in 1994 US West obtained a similar ruling in the U.S. District Court for the Western District of Washington. The other Regional Bell Operating Companies ("RBOCs") have each filed similar challenges to the constitutionality of the cross-ownership ban in federal district courts in their service areas, as has the United States Telephone Association on behalf of its members. 109. Overview of LEC Applications for VDT trials and for Permanent Services. Since adoption of the VDT regulatory framework, the Commission has granted applications by five different LECs for technical and market trials. Five additional applications for new or expanded trials are pending before the Commission. The cost estimates for the various trials range from $2.5 million to $11 million and cover between 250 to 2000 households per trial. Twenty-four applications for permanent commercial VDT service have also been filed with the Commission, including applications by six of the seven RBOCs, as well as GTE. These applications propose VDT platforms using various distribution technologies which, if granted, would provide service to over 8.5 million homes. 110. In July 1994, the first permanent Section 214 authorization was granted to New Jersey Bell for Dover Township. Pursuant to that grant, New Jersey Bell is authorized to construct and operate a system to provide VDT service to approximately 38,000 homes using a FTTC architecture, with coaxial cable and copper wire for the final link to the home and providing initial digital capacity of 64 channels, conditioned upon expanding capacity to 384 digital channels by January 3, 1995. FutureVision of America, Corp., the initial programmer-customer, is limited to a maximum of 32 channels (half the initial channel capacity) during the six-month interim transition period from a 64 channel system to a 384 channel system. 111. Reports on the status of the trials have been submitted by Bell Atlantic and NYNEX, and a tariff has been filed by Rochester Telephone. In other filings and comments in this proceeding, various LECs have proffered their views on the status of VDT and current technology. 112. Technology and Architecture Issues. In addition to regulatory and legal constraints discussed above, technology has also played a role in restraining the entry of LECs into the multichannel video programming distribution marketplace. While an infrastructure owned by telephone companies currently exists for delivery of narrowband voice communications to most homes and businesses in the nation, that infrastructure is unable to transport and deliver multichannel video programming to multiple end users. Various techniques, technologies and architectures for delivering broadband video signals are currently being tested. Some of these include: optical digital loop carrier systems, fiber to the node ("FTTN"), fiber to the curb ("FTTC"), fiber to the home, hybrid fiber-coax networks ("HFC"), asynchronous digital subscriber line ("ADSL"), and various broadband switches. For a brief description of these technologies, see Appendix B. 113. Initially, US West asserts that analog-based transmission appears to be preferable to digital from the perspective of end user access and program availability. However, analog channels impose capacity requirements that limit the expandability of VDT offerings. NYNEX's report on the status of its VDT trial indicates that its trial platform provided sufficient analog channel capacity to accommodate all parties requesting direct access to such channels, but was unable to provide sufficient stored access capacity. GTE believes that compression capabilities will have a competitive impact beginning in 1995. Other commenters assert that the limitations of analog may cease to be a constraint when the price of analog-to-digital conversion declines significantly and more programming is digitally encoded. GTE predicts that digital compression will be readily available during 1995, and broadband switching sometime during 1996. 114. The ability of LECs to use their existing infrastructure to offer video services may also play a role in the deployment of VDT as an effective competitor to cable. Just a few years ago, industry projections for upgrading the telephone infrastructure by installation of fiber optics suggested that VDT deployment could only be slated for the next century. However, with new technologies and architectures, those projections have changed significantly. For example, ADSL technology and integrated HFC networks are both expected to speed deployment of VDT. Bell Atlantic's report on the status of its technical trial notes that while technical difficulties were experienced with some of the prototype video decoders, ADSL is "proving to be a successful medium for delivery of voice, video and data services." Rochester Telephone, however, notes that current ADSL technology is capable of delivering only one retransmitted broadcast signal to a customer, i.e., end users are able to select only one programmer-customer at a time from the available service providers using the ADSL system. GTE notes that information about customer satisfaction and the migration path for ADSL technology (e.g., to accommodate High Definition Television ("HDTV")) are not known. Bell Atlantic projects that recent innovations in encoding, compression and multiplexing technology are expected to permit delivery of "live" broadcast programming over copper loops beginning in 1995, and that digital pointcast capability using broadband switching technology will become generally available beginning in 1996. 115. With respect to end-user concerns, NYNEX notes that tests of the hybrid fiber- coax architecture demonstrate that if two customers are served by the same drop, it is not possible for both customers to choose different programmers. Nevertheless, NYNEX reports that the hybrid fiber-coax network is successfully delivering direct and stored access analog VDT services, and that the baseband analog switch is effectively delivering menu service and video and audio signals from multiple video information providers to the end users, who have access to interactive services. Switched access has not yet been introduced on the NYNEX analog platform because the analog format is not capable of managing sessions for video-on-demand applications. In other contexts, however, GTE asserts that technology is currently available to provide enhanced video services packaging for consumers. 116. Regulatory and Statutory Issues. LECs commenting in this proceeding assert that there are two reasons why VDT service has not yet proven itself as a viable competitor to cable service: (1) the statutory ban on the provision of video programming by LECs to subscribers in their own service area; and (2) the fact that the Commission has not yet granted most of the Section 214 VDT applications. The LEC commenters recommend: (1) repeal of the 1984 Cable Act's ban on LEC provision of video programming; (2) expedition, streamlining or elimination of the Section 214 application process; (3) continued resistance to the imposition of local franchise requirements on LECs; and (4) regulatory parity with cable. GTE asserts that adjustments in the rate regulation framework for the cable industry should correspond with relaxation of LEC price caps, such that both industries are provided incentives to compete on the basis of price and service. As noted above, the Commission has recommended to Congress the repeal of the cable-telephone company cross-ownership ban, and is processing Section 214 applications to provide VDT service. 117. In addition to the hurdles to providing VDT service facing all LECs, the BOCs also must comply with the Modified Final Judgment ("MFJ"). As noted above, the MFJ ban on BOC provision of interLATA services prohibits BOCs from receiving satellite or over-the- air video signals -- which is how cable systems typically receive most of their programming -- without obtaining a waiver of the MFJ. The interLATA ban could also prevent interLATA offering of enhanced gateway services. 118. GTE asserts that the length of time it will take for video dialtone to become an alternative to cable will depend on the LECs' respective market entry rates. Most LECs have announced deployment schedules of five- to ten-year periods. Trade press reports suggest that the BOCs hope to make video-capable networks available to over twenty million homes by the turn of the century. 119. Reporting Issues. In response to the questions posed in the NOI regarding appropriate means for assessing the future competitive impact of VDT, nearly all of the commenters argue that data gathered in the technical and marketing trials is highly confidential and proprietary and should not be disclosed to potential competitors; (2) that sufficient information pertaining to system location, subscriber base, channel capacity and pricing will be provided in tariff filings; and (3) that customer proprietary information should not be required to be publicly disclosed in the future. Disclosure of the total number of homes passed by VDT systems is deemed appropriate by the commenters, however, so long as such data is provided on a zip code, or Metropolitan Statistical Area, or state-wide basis. The LECs also assert that subscribership, program offering, and price information should be gathered from programmer-customers who lease transmission capacity on the VDT platforms. 120. Conclusion. A number of issues remain unresolved with respect to the participation of LECs in the delivery of video programming. The regulatory framework for permitting LECs to construct and operate a common carrier VDT platform for the transmission of video programming and other services to end-users is under review by the Commission. Moreover, legislation proposing, among other things, to eliminate the telephone company- cable company cross-ownership ban is pending before Congress. As noted above, the VDT industry is in its initial planning and construction phases. In future reports, the Commission will further review the development of LEC provision of video programming and its status as a competitive alternative to cable. 2. Local Multipoint Distribution Service (LMDS) 121. LMDS is a new technology, similar to MMDS, in which multiple channels of video programming are transmitted using high-frequency microwave channels in the 28 GHz band. Like MMDS, LMDS subscribers must have a special antenna that is located with a line of sight to the transmitter. Because of the propagation characteristics in this frequency band, LMDS requires multiple transmitters in "cells" with radii of three to six miles in order to cover a metropolitan area that could be covered by a single wireless cable transmitter. 122. In 1991, the Commission authorized the Suite 12 Group to provide LMDS. Operating as CellularVision of New York ("CVNY"), it operates its LMDS system in Brooklyn, New York, and provides forty-nine video channels, including two premium movie channels for $29.95 per month. CVNY states that a comparable package from local cable operators would cost $10-20 more per month. CVNY also claims that LMDS provides higher picture quality than is available with cable, and that LMDS could be used as a platform for telephony as well as video programming. Moreover, CVNY predicts that LMDS will be capable of using digital compression technology whenever it becomes commercially available. CVNY reportedly has "a few hundred" subscribers. 123. In 1991, the Commission stated that while "it is still too early in the development of LMDS to reach firm conclusions on the treatment of LMDS providers as multichannel video programming distributors," the Commission will analyze LMDS providers "for purposes of the effective competition determination in a manner appropriate to the degree of video distribution services they provide." 124. In response to proposals from parties who wish to provide services other than LMDS in the 28 GHz band, the Commission sought and received approval to conduct a negotiated rulemaking among interested parties. One of these parties, Teledesic Corporation ("Teledesic"), which has filed an application with the Commission to provide FSS (fixed satellite service) in the 28 GHz band, submitted comments in this proceeding stating that LMDS would merely duplicate the video entertainment being provided by cable, MMDS, DBS and video dialtone offerings. Teledesic also contends that LMDS has not yet proven its feasibility on a large scale, and therefore, that the Commission should not assume that LMDS could provide competition to cable. 125. Because the Commission has not yet determined whether the 28 GHz band will be designated for use by LMDS operators, it is premature for the Commission to draw any conclusions in this Report regarding the feasibility of LMDS or the desirability of a particular outcome of the negotiated rulemaking. If the Commission ultimately concludes that LMDS is to be licensed in the 28 GHz band, LMDS will be included in future reports to Congress. 3. Low Power Television (LPTV) 126. Low power television ("LPTV") refers to use of the VHF and UHF spectra pursuant to the regulatory scheme that was established by the Commission in 1982 as a means of increasing diversity in television programming and station ownership. Although this service has been highly successful in meeting that objective, there is now interest in using LPTV channels to provide multichannel video service. 127. The Commission's rules specifically permit LPTV channels to be used for "subscription television," whereby a licensee charges subscribers a fee for the provision of one or more scrambled channels and the equipment needed to descramble the signal. Unlike a full-service television station, an entity may hold more than one LPTV license in a particular market. Therefore, an LPTV operator can accumulate a number of channels in a single market to provide multichannel video service. However, the Commission is presently not accepting applications for new LPTV stations for service within 100 miles of the top thirty-six United States cities in order to preserve spectrum availability for the implementation of HDTV systems by full-service stations. 128. Despite that partial application freeze, the Commission received a significant number of LPTV construction permit applications in April 1994. According to an industry report, the interest in obtaining LPTV licenses is the result of a growing interest in providing multichannel LPTV service, and may also have been enhanced by the fact that signal scrambling methods have become more economical and advanced. 129. The Commission is aware of at least one company that presently provides multichannel LPTV service. Reports indicate that Broadcast Services International, Inc. ("BSI") provides multichannel LPTV service to approximately 500 subscribers in Duluth, Minnesota and to 250 subscribers in nearby Ely, Minnesota. BSI is reportedly focussing its efforts on uncabled rural areas, and it is unclear to what extent BSI's service would be a competitive substitute for cable service. Another possible LPTV site involves Selma, Alabama, where construction permits for multiple LPTV station assignments have been issued to a single applicant. In addition, many of the applications received in April 1994 are for multiple LPTV channel assignments, primarily for rural markets. 130. While multichannel LPTV services may eventually become available in many areas, the application freeze on new LPTV stations within 100 miles of the thirty-six largest United States cities and the spectrum needs of advanced television systems suggest that multichannel LPTV entry will likely be limited to smaller and mid-sized markets. In addition, it is unclear whether multichannel LPTV will enter the market as a competitor to cable, or as a substitute to cable service in largely uncabled areas. 4. Electric Utilities 131. Electric utility companies may provide another potential source for the delivery of video programming. Some municipal electric utility companies are actively engaged in overbuilding privately-owned cable systems, or are presently contemplating such overbuilding. As is the case with LEC provision of VDT services, the need for appropriate safeguards to avoid cross-subsidization between regulated and video distribution businesses is an issue associated with entry by electric utility companies. 132. Electric utilities' interest in cable television is based on the potential for capitalizing on their existing rights of way, and from the potential for using "demand-side" load management capabilities for the distribution of video programming. "Demand-side" management involves, inter alia, a utility's ability to control or limit increases in demand for electricity during peak hours, for example by controlling its customers' air conditioners or pool-heaters through the installation of a broadband communications link to each home. 133. As discussed in Section III.B.1, supra, the GEPB (Glasgow Electric Plant Board) in Glasgow, Kentucky is an example of a utility currently providing cable service. GEPB's initial purpose in creating its fully-interactive communications and control systems was simply to find a better way to manage its distribution network, and to reduce energy costs to consumers by monitoring consumption. In June 1989, GEPB began offering cable television service to all 13,000 of its customers in competition with the local cable operator, and it has since acquired fifty percent of the market for cable television service. 5. Video Cassette Recorders (VCRs) 134. VCRs (video cassette recorders) are not "multichannel video programming distributors." However, the Commission noted in the 1990 Cable Report that widespread ownership of VCRs allows many viewers to see over-the-air programs at times other than when they are broadcast, and also permits those viewers to choose pre-recorded tapes on a variety of subjects, giving them more control over both the programming they watch and the time they watch it. The evidence in that proceeding demonstrated that VCR penetration had grown dramatically, reaching a penetration level of 72% in 1990, up 30% from 1986. Moreover, the Commission found that nationwide revenues from the sale and rental of video cassettes exceeded the revenues for basic cable service. Therefore, the Commission concluded that high VCR penetration levels and video cassette rentals, combined with broadcast or other over-the-air video delivery systems, offer an alternative that may act as a partial substitute for cable services. 135. Since the 1990 Cable Report was released, VCRs have become still more prevalent. Time Warner states that by the end of 1993, there were approximately 80.5 million households with VCRs, which compares to approximately 57 million cable households at that time. Although those 80.5 million households with VCRs would account for nearly 84% of all television households in the United States, a study conducted by the Commission following its release of the 1990 Cable Report found that VCRs are more properly categorized as competitors of premium or pay-per-view cable programming, rather than of cable services generally. IV. MARKET STRUCTURE CONDITIONS AFFECTING COMPETITION 136. In this section of the Report, the Commission discusses the status of horizontal concentration and vertical integration in the cable television industry, and the competitive effects of that concentration and integration. In brief, the Commission finds that horizontal concentration has increased moderately since it released the 1990 Cable Report. Vertical integration among programmers and cable operators, on the other hand, has not changed significantly. As part of its responsibility for implementing the 1992 Cable Act, the Commission has adopted and enforced rules to mitigate the anticompetitive effects of such integration on entry of new competitors. Those rules appear generally to be effective in ensuring that those new competitors can gain access to programming produced by vertically- integrated cable companies. Finally, the Commission discusses in the concluding paragraphs of this section certain technological developments that have the potential to change the structure of the industry. A. Horizontal Concentration In The Cable Industry 137. In the 1990 Cable Report, the Commission noted that horizontal concentration in the cable industry had significantly increased on a nationwide basis since the passage of the 1984 Cable Act. The Commission concluded that horizontal integration had not only "brought substantial benefits to American consumers, but also has added potential for certain anticompetitive conduct." The benefits included more efficient production as a result of certain economies of scale, and the creation of a pool of capital for investment in programming. The potential anticompetitive effects, on the other hand, included the danger that the larger MSOs would use their size to "extract unreasonable concessions from program suppliers and to unfairly restrain competition from alternative distribution services." The Commission did not express an opinion in the 1990 Cable Report as to whether the observed increase in horizontal integration was desirable. The Commission did state, however, that it intended to continue monitoring changes in concentration. 138. The language of the 1992 Cable Act clearly indicates that Congress recognized the potential for both beneficial and harmful effects from increased horizontal concentration. In Section 11(c) of the 1992 Act, Congress directed the Commission to establish "reasonable limits on the number of cable subscribers a person is authorized to reach through cable systems owned by such person, or in which such person has an attributable interest." Moreover, Congress required the Commission to consider a number of specific public interest objectives when it established those limits. Those requirements reflect Congressional recognition that there are benefits to increased concentration, including the fact that as compared to smaller system operators, large MSOs can more easily risk providing more diverse, innovative, narrowly targeted, and controversial programming. On the other hand, those requirements also reflect a recognition by Congress of the potential for large MSOs to extract concessions from cable programmers in exchange for carriage of their programming, which could discourage entry of new programming services and adversely impact the diversity of programming available for consumers. 139. Pursuant to Section 11(c) of the 1992 Cable Act, the Commission promulgated horizontal ownership rules. Those rules prohibit any entity from having an "attributable interest" in cable systems that reach more than thirty percent of all homes passed nationwide by cable, or thirty-five percent if the additional systems are "minority-controlled." In deciding upon those percentages, the Commission stated that it was balancing two Congressional concerns. In particular, the Commission said: A 30% horizontal ownership limit is generally appropriate to prevent the nation's largest MSOs from gaining enhanced leverage from increased horizontal concentration. Nonetheless, it also ensures that the majority of MSOs continue to expand and benefit from the economies of scale necessary to encourage investment in new video programming services and the deployment of advanced cable technologies." 140. After a federal district court ruled that Section 11(c) of the 1992 Cable Act is unconstitutional, the Commission stayed enforcement of its horizontal ownership rules pending appellate review. In addition, the horizontal ownership rules currently are under reconsideration by the Commission. 1. Status of Concentration in the Cable Industry 141. In most of the local markets where cable operators provide cable service to subscribers, they remain the sole distributors of multichannel video programming. As noted above, there are limited instances of competition through overbuilding in the United States. In addition, suppliers that use technologies other than cable have not yet reached the subscribership levels necessary for the Commission to conclude that vigorous rivalry currently exists in most local markets for multichannel video distribution. 142. There has been a moderate increase in the nationwide horizontal concentration of the cable industry since the issuance of the 1990 Cable Report, as measured by the Herfindahl-Hirschman Index ("HHI"), which is a standard measure of horizontal concentration. Whether an HHI measurement, or any measure of concentration at the national level, is meaningful depends on the existence of a national cable market. As is discussed above, the relevant market for the purpose of analyzing competition in the cable industry is generally local, although there may be larger markets in the future, should other technologies become competitive. When examining issues involving cable programming, however, the relevant geographic market may well be national, and in that context, the HHI provides more useful information. 143. In 1990, the national market for the distribution of cable services was unconcentrated, with an HHI of approximately 866. The largest MSO, TCI, had a 24% market share. Taken together, the top four companies had a 47% market share; the top ten had 63%. Between that time and the end of the first quarter of 1994, the market remained "unconcentrated" in terms of horizontal concentration. The HHI for the industry as of March 31, 1994, is 898, which represents a modest increase since 1990. TCI still had the largest market share, 24.8%, an increase of less than one percentage point since 1990. The top four companies still had 47% of the market, and the top ten 63%. 144. At the end of the first quarter of this year, the individual market shares of the rest of the top ten MSOs was as follows: Time Warner was the second largest MSO, with 12.5% of the market; the third largest MSO, Continental, and the fourth largest, Comcast, each had approximately 5% of the market; the fifth largest MSO was Cablevision, which had a little less than 4% of the market; the sixth was Cox Cable Communications, Inc. ("Cox"), with a little more than 3%; and the seventh through tenth MSOs each had between 2.25% and 2.5% of the market. 145. By the middle of September, 1994, however, transactions had been announced that would significantly alter the market shares of those top ten companies. Three significant mergers have been announced, all of which are expected to be consummated in the near future: (1) the largest MSO, TCI, has agreed to acquire TeleCable, which would add over 700,000 subscribers to TCI's total, increasing its market share to 26.1%; (2) Comcast has agreed to acquire from Rogers (Rogers Communications) those systems in the United States that Rogers acquired from Maclean Hunter earlier this year, which will give Comcast a 5.6% share and move it from fourth place to third place; and (3) Cox, the sixth largest MSO on March 31, 1994, agreed to acquire Times Mirror Cable Television ("Times Mirror"), which would give Cox a 5.4% share of the market, and make that combined entity the fourth largest MSO, right behind Comcast. In addition to those mergers, Time Warner agreed in September 1994 to (1) consolidate in a joint venture certain of its systems with those operated by Newhouse Broadcasting Corp. and Advanced Publications, Inc., and (2) purchase Summit Communications Corporation (which has 160,000 subscribers). Those transactions will give the second largest MSO, Time Warner, operating control of the seventh largest MSO, causing Time Warner's market share to increase to 15.21%. 146. If the four transactions listed above are consummated, the HHI will rise to approximately 1051. Standard antitrust analysis considers a market with an HHI between 1000 and 1800 to be "moderately concentrated." According to the guidelines developed by antitrust enforcement agencies, "[m]ergers producing an increase in the HHI of more than 100 points in moderately concentrated markets post-merger potentially raise significant competitive concerns depending on [various] factors . . ." None of the four announced mergers would individually increase the HHI by 100 points. 147. When the Commission established limits for horizontal concentration on a national level, it declined to impose regional limits, concluding that "the benefits and efficiencies of regional concentration outweigh any anti-competitive effects in the local programming and advertising marketplace." At this time, the Commission does not have much evidence concerning regional concentration. Bell Atlantic notes that MSOs have been swapping territories with each other, and sees a trend towards large-scale regional concentration of MSOs. 2. Competitive Effects of Horizontal Concentration 148. The comments and reply comments that the Commission has received in this proceeding generally reiterate both the benefits and risks of increased horizontal concentration that have previously been described by both Congress and the Commission in the legislative history of the 1992 Cable Act, the 1990 Cable Report, and in the horizontal ownership rules. One commenter, TCI, provided additional information addressing the issue whether increased horizontal concentration could adversely affect entry of new programming services -- in its view, whether one MSO can accumulate through acquisition a "critical mass" of subscribers to which all programmers must gain access in order to survive or succeed. Such an MSO would be able to dictate terms to programmers, and in effect, dominate the market for cable television programming. TCI, the largest MSO, with approximately twenty-five percent of the nation's subscribers, denied that it had access to the critical mass of subscribers necessary to make or break a new programming service. Further, it asserted that a large MSO has no rational incentive to restrict its purchases from programmers, or its supply of programming to cable subscribers, by exercising purchasing power over programming suppliers. 149. As shown herein, the persistence of high concentration at the local level tends to impair market performance. In addition, Congress and the Commission have noted that greater national concentration may have both adverse and pro-competitive effects. On the one hand, large MSOs have assisted in the creation and survival of new and underfinanced programmers. On the other hand, those same MSOs may have used their programming purchasing power to deter the entry of new cable programmers or competitive alternatives to cable. To the extent that large MSOs used their power over vertically-integrated programmers to obtain exclusive distribution rights to satellite-delivered programming, and those exclusive rights disadvantaged competitors of those large MSOs, the 1992 Cable Act's program access provisions and the Commission's program access rules appear to have largely addressed the problem. 150. Concentration at the national level enables cable operators to achieve certain efficiencies, such as discounts for programming. Programming costs are a significant portion of total operating costs, accounting for about thirty-six percent of expenditures. Lower prices for programming result from two aspects of firm size. First, given that many programmers grant quantity discounts based on the number of subscribers, larger MSOs will pay lower prices for programs than their non-MSO counterparts. Second, the largest MSOs also may be able to exert superior bargaining power, and thereby, negotiate significant discounts for programming. Lower prices for programming are not, in themselves, a cause for concern. Discounts on programming can significantly lower the cost of packaging and distributing the cable product. Lower costs also might increase the profits of an MSO which can, in turn, use those funds to increase the supply and quality of programming. However, greater programming discounts, if unfairly and discriminatory granted, may be a competitive concern. 151. Concentration in regional, or locally clustered, marketing areas may also be pro- competitive or anti-competitive. Regional concentration may result in significant efficiencies. A centrally-located regional installation and maintenance office can perform those functions for a number of nearby markets, allowing more efficient use of high-capacity, productive assets. Duplication of other factors of production, such as management, billing, and office space, may also be eliminated by regional clustering. Advertising, marketing and sales functions might realize such economies as well. Larger firms may also realize economies in the purchase of inputs of production, such as programming. Moreover, it may be possible to spread fixed headend costs over a large number of subscribers using fiber optic links. If fiber optic links are substituted for headends, some scale economies could be achieved by eliminating duplication of headend equipment. That flexibility may allow cable firms to adopt more efficient system sizes, and thereby, lower their costs. 152. The sharing of fixed resources required for the deployment of innovative services, including video-on-demand, may also be characteristic of regional economies of scale. Interlinked cable systems will eliminate the need for costly duplication of expensive capital equipment required for these new services. If duplication is required, the access costs related to innovative services may not warrant their provision in less densely populated or rural cable markets. However, if a group of markets were all served from a central location, a standard product could be served to all customers within the cluster. If so, consumers will benefit as the new services will be deployed more rapidly to all markets. 153. Clustering may also reflect the desire of cable operators to enter the telephone business, or it may reflect strategic decisions by cable operators to position themselves to compete against LECs that are poised to enter the market for the distribution of multichannel video programming. Creating large geographic regions of contiguous cable markets may allow a single MSO to construct more cheaply the network necessary to provide telephone services on a wide scale. By connecting the contiguous systems with fiber optic links, a large regional cable firm may be able to compete better in both voice and video distribution with the RBOCs, which serve large geographic regions. Future cable networks that offer multiple services (voice, video, and data) may require companies to serve larger markets in order to fully take advantage of economies of scale and scope. Therefore, clustering may be viewed as pro-competitive both in terms of cable companies' entry into the market for switched voice and data services, and in terms of positioning themselves for potential competition from LECs in the market for video programming 154. There are, however, competitive risks associated with increased regional clustering of commonly-owned cable systems. The creation of large, contiguous clusters of commonly-owned systems may result in the removal of cable systems that are not affiliated with large MSOs from significant regions of the country. Those "independent" systems may serve presently as a competitive constraint, offering a credible threat of expansion into adjacent markets. If high capital expenditures discourage entry, then adjacent systems may be the most likely entrants, because such systems may be able to use parts of their existing cable plant to support expansion into adjacent areas. The elimination by acquisition of these potential competitors may increase the market power of clustered systems by decreasing the likelihood of entry. 155. A possible consequence of the accumulation of large regional clusters of interconnected cable systems is that such systems may send an entry-deterring signal to potential rivals. When a firm incurs substantial sunk costs by investing in its operations, it signals a long-term commitment to the market. Cable firms making the first move to provide a fiber-based broadband network may dissuade potential entrants from entering the market, or cause then to enter on a smaller scale. For example, a commitment by an MSO to build an integrated broadband network capable of delivering a wide variety of services may discourage the more limited wireless systems from investing in particular markets. Moreover, increased concentration in tightly clustered markets may also enable the few surviving cable operators to coordinate their conduct, with the effect of raising rivals' costs. Nevertheless, major sunk cost investment by cable systems should expand and improve the quality of services provided to subscribers. Therefore, there may exist complex tradeoffs between the potential consumer benefits that are provided by the sunk cost investments of incumbent cable systems and the potential consumer benefits that new entrants may offer consumers if not deterred by incumbent cable systems. 3. Conclusion 156. The record in this proceeding shows that horizontal concentration in the cable industry has increased moderately since 1990. If the recently announced mergers are consummated, they will result in a further increase in concentration. The Commission will monitor further changes in concentration, and will complete its reconsideration of the horizontal concentration rules. Furthermore, the Commission will continue its analysis of the possible economic efficiencies and inefficiencies of horizontal concentration. Finally, the Commission will continue to evaluate issues associated with industry mergers as required by its implementation of the horizontal ownership provisions of the 1992 Cable Act, as well as by its public interest responsibilities under other provisions of the Communications Act. B. Vertical Integration in the Cable Industry 157. In the 1990 Cable Report, the Commission found that vertically-integrated cable operators have the ability to deny competing MVPDs access to programming services in which cable operators have ownership interests. The Commission concluded that such practices could jeopardize the viability of new competition to cable. The Commission also observed that programming services, particularly new ones, at times had difficulty obtaining carriage on cable systems. 158. In response to similar record evidence and in order to promote competition in the program supply and distribution markets, Congress enacted provisions of the 1992 Cable Act that limit the ability of vertically-integrated satellite programming vendors and cable operators to inhibit competitive entry into both the programming supply and distribution markets. Specifically, Section 11 of the 1992 Cable Act required the Commission to adopt, inter alia, restrictions on the number of channels on a cable system that can be occupied by programming services in which the operator has an attributable interest. Section 12 of the 1992 Act prohibits cable operators and other MVPDs from: (1) requiring that they have a financial interest in a programming service as a condition for carriage; (2) coercing programming vendors to provide exclusive rights as a condition of carriage; and (3) discriminating on the basis of affiliation of vendors in the selection, terms or conditions of carriage. Finally, Section 19 of the 1992 Act prohibits unfair methods of competition and proscribes several specific practices by vertically-integrated satellite cable programming vendors, satellite broadcast cable programming vendors, and cable operators, including, in certain circumstances, the granting of "exclusivity" provisions in cable carriage contracts. 159. On April 1, 1993, the Commission implemented Section 19 by adopting rules that prohibit unfair and discriminatory acts and prohibit or limit the types of exclusive programming contracts that may be entered into between cable operators and vertically- integrated programming vendors (the "program access rules"). On September 23, 1993, the Commission issued rules implementing Section 11, which restrict the number of channels on a cable system that may be occupied by programmers affiliated with the owner of that system (the "channel occupancy rules"). In a separate order, also issued on September 23, the Commission adopted rules implementing Section 12 of the Act, which prohibit cable operators from coercing programming vendors into granting them exclusive rights and from discriminating against program suppliers on the basis of the operators' ownership interests (the "program carriage" rules). 160. As discussed in the following sections, the level of vertical integration in the cable industry has remained at roughly the same level as found in the 1990 Cable Report. However, the program access provisions of the 1992 Act and the Commission's implementation of its program access rules have helped ensure that satellite-delivered programming is made available to competing MVPDs and has reduced the gap between programming prices paid by cable operators and their competitors. Moreover, since 1990, there has also been growth in the diversity and quality of programming services that are offered or whose launch has been announced. Although the Commission believes that its program access rules have generally been successful in ensuring the supply of programming to competing MVPDs, there remain a number of unresolved issues relating to vertical integration that require further attention. 1. Status of Vertical Integration in 1994 161. While the number of vertically-integrated national programming services has grown substantially since 1990, so too has the overall number of programming services available for distribution. Consequently, approximately 53% of programming services are integrated with cable system operators today, compared with 50% of programming services that were vertically integrated in 1990. 162. The Commission noted in the 1990 Cable Report that all of the successful channels that were introduced after passage of the 1984 Cable Act were affiliated with cable system operators, and today, vertically-integrated national programming services continue to dominate the group of services that are most widely viewed. Twelve of the top fifteen most- watched services, according to prime-time rankings, are vertically integrated, an increase from ten in 1990. Cable operators have interests in fifteen of the top twenty-five services, an increase from thirteen in 1990. It is too early to determine, however, whether vertically-integrated services that have been introduced since 1990 will be more successful than their non-integrated counterparts. 163. There has been only moderate change since 1990 in cable system ownership of the most popular programming services. All but three of the top twenty-five programming services listed in the 1990 Cable Report are still in the top twenty-five. One of the three services that have entered the top twenty-five since 1990, Comedy Central, has cable ownership interests, and two, EWTN and Prevue Channel, are not vertically integrated. Since the 1990 Cable Report, cable operators acquired ownership interests in two of the top twenty-five services and divested interests in one. 164. In total, cable operators have acquired interests in eight existing programming services that had no cable ownership in 1990. Those include the April 1994 acquisition of Paramount Communications, Inc., by Viacom International, Inc., in which Viacom acquired ownership interests in the USA Network and the Sci-Fi Channel. TCI/Liberty Media also acquired a controlling interest in the Home Shopping Network, which offers two programming services. Gaylord Entertainment ("Gaylord"), an owner of three cable systems, acquired Country Music TV, The Nashville Network and superstation KTVT. 165. During this same period, cable operators divested themselves of five existing programming services. Viacom sold its interest in Lifetime to Hearst and Capital Cities/ABC. Cablevision sold its interest in CNBC to NBC. Nostalgia and The Travel Channel were reported in 1990 as having MSO ownership, but since then, cable operators have divested those interests. Finally, a few of the programming services listed in the 1990 Cable Report have gone bankrupt or have merged with other services. The Fashion Channel, a financial investment of TCI, went bankrupt in 1991. In late 1992, VISN, a TCI investment, merged with American Christian TV System ("ACTS") to form the Faith and Values Channel, in which TCI has no ownership interest. 166. Since 1990, thirty-six new programming services have been launched, twenty- two of them since the passage of the 1992 Cable Act. Of the services launched after 1990, twenty are owned in part by one or more cable operators. The Commission has examined the market penetration growth of the fourteen new services that had more than one million subscribers after their launch, the results of which are set forth in Table 4.1. Table 4.1 Average Market Penetration of New Programming Services Market Penetration at Launch Market Penetration after One Year Market Penetration after Two Years Services with Cable Ownership 7.17% 11.11% 20.83% Services with No Cable Ownership 5.35% 8.66% 7.75%* * Based on information for only two services. It appears that vertically- integrated services, on average, achieved greater market penetration in their first two years than services without cable ownership. On the other hand, ESPN2, a new service with no cable ownership, had the highest penetration at launch of any new programming services and continues to grow at a steady rate. 167. Currently, there are fifty-six vertically-integrated programming services. They are owned, in whole or in part, by only twenty MSOs. Twelve of those MSOs have at least a five-percent interest in one or more of the fifty-six services, which qualifies as an "attributable ownership interest" under the Commission's program access rules. An additional eight MSOs hold ownership interests of less than five percent in one or more of those services. 168. Nine of the ten largest MSOs have attributable ownership interests under the program access rules in one or more of these fifty-six programming services. The four largest MSOs have partial ownership interests in seven of the fifteen most popular services and in nine of the top twenty-five. TCI/Liberty Media, the nation's largest MSO, has attributable interests under the program access rules in twenty-three national programming services, which amounts to approximately 22% of the available programming services. Time Warner, the nation's second largest MSO, has attributable interests in sixteen national programming services, or approximately 15% of those available. In contrast, in 1990, TCI held interests in twenty-two national programming services, which was 28.5% of the programming services available at that time. In 1990, Time Warner had interests in eight national programming services, representing 10% of available programming services. 169. Twenty-four of the fifty-six vertically-integrated national programming services are owned, in part, by a single MSO having a 50% or greater ownership interest. Viacom has a 50% or greater interest in twelve services, three of which are ranked among the top fifteen national programming services. TCI/Liberty Media has a 50% or greater interest in three services. Gaylord has a 50% or greater interest in three of the top fifteen national programming services. Four other MSOs have 50% or greater ownership interests in one or two services each. 170. There are nineteen national programming services that are each owned, in part, by several MSOs whose ownership interests, if aggregated, would comprise a majority interest in that programmer. Five of those are among the top fifteen services. In contrast, there are only two vertically-integrated programmers that are each owned, in part, by several MSOs, whose ownership interests, if aggregated, would constitute a minority interest in that programmer. In addition, there are five vertically-integrated programming services that have only one MSO with a minority ownership interest. 171. Also included in the fifty-six vertically-integrated services are the two C-SPAN networks. Those services are considered programming services with cable interests because they receive funding from their cable affiliates. However, according to NCTA, cable operators have no ownership in, or program control over, the C-SPAN services. Finally, there are four national programming services about which NCTA stated that cable system operators had ownership interests, but for which the Commission does not have information regarding the identity of the MSOs that hold the interests, or the amount of those interests in the identified services. 172. To complete the picture of vertical integration in national programming services, the Commission notes that ABC, NBC, and Fox, each own national programming services. ABC holds an eighty-percent ownership interst ESPN and ESPN2, has a fifty- percent interest in Lifetime and has a minority interest in A&E. NBC owns CNBC and America's Talking, has a fifty-percent interest in Bravo and has minority interests in A&E, AMC, and Court TV. Fox owns fX and Fox Net. 2. Competitive Effects of Vertical Integration a. Competitive Access to Programming 173. Commission Enforcement Activities. In contrast to the "substantial evidence of specific problems concerning program access" that were noted in the 1990 Cable Report, the commenters in this proceeding have not complained about widespread unavailability of programming to distributors competing with cable operators. For example, DirecTV states its belief that the program access provisions in the 1992 Cable Act and the Commission's regulations provide the most effective means for the development of competition to cable. Moreover, the NCTA submits that the program access rules have facilitated increased competition in the video marketplace, and provide more than adequate remedies for instances of unfair conduct by vertically-integrated programming vendors. These comments are consistent with the relatively small number of complaints filed with the Commission concerning denial of access to programming on the grounds of exclusivity agreements. 174. From November 1993, when the program access and carriage agreement regulations took effect, through June 30, 1994, only twelve program access cases were filed; eleven have since been resolved. The Cable Services Bureau has asked for additional information in the one unresolved case. Most of the eleven resolved cases involved exclusivity issues. 175. Another nine cases were filed since late July 1994, and the pleading deadlines in those cases expire in September or October of 1994. Six of those late-July filings involve allegations of price discrimination brought by a single programming distributor. Two of the unresolved matters involve requests by CVI for Sci Fi Channel exclusivity and by Lenfest Communications (fifty-percent owned by TCI/Liberty Media) for exclusivity for a local news service. One additional price discrimination complaint was filed in September. In total, the Commission has received fifteen complaints, five petitions for a finding that exclusivity is in the public interest, and one petition for a waiver of the rules. 176. Two resolved cases involving petitions to the Commission to permit exclusive agreements between vertically-integrated programmers and cable operators are of particular note. In one of those matters, Time Warner filed a petition for exclusivity with regard to the Court TV network. In denying the petition, the Commission first concluded that a party seeking to show that an exclusivity agreement is in the public interest bears the burden of demonstrating that the public interest benefits from exclusivity outweigh its presumptively anticompetitive effects on competing distributors. The Commission then found that continued enforcement of Time Warner's exclusive agreement for the distribution of Court TV adversely affected Liberty Cable's ability to compete effectively in the Manhattan market and would be likely to have similar effects in other markets. The Commission further found that no countervailing public benefits would be derived from the proposed exclusivity. Because Court TV is a viable, successful programming service with a broad and growing national appeal, as shown in part by its thirteen million subscribers, exclusivity was not found to be necessary for survival of the service or to promote diversity in programming. Accordingly, the Commission concluded that continued enforcement of Time Warner's contract with Court TV was not in the public interest. 177. In the second case, the Commission found that New England Cable News ("NECN"), a regional news programming source that is fifty-percent owned by Continental Cablevision, had shown that exclusivity was critical to attract investment and secure distribution, which was essential to its financial viability. NECN also showed that exclusive distribution would foster diversity. The Commission found that exclusivity would not have an adverse effect on the development of competition with the cable systems affiliated with it. Therefore, the Commission found that reasonably-tailored exclusivity was in the public interest and granted NECN's petition with certain limits as to the duration of exclusivity. 178. The Commission's enforcement of the program access provisions appears to be meeting one of the goals of Section 19 of the 1992 Cable Act -- ensuring access by competing MVPDs to satellite cable programming from vertically-integrated programming services. There remain, however, several unresolved program access issues, which the Commission considers below. 179. Access to Programming of Non-Vertically-Integrated Vendors. Several commenters, such as WCA, People's Choice, American Telecasting ("ATEL") and Liberty Cable, advocate extension of the statutory prohibitions and requirements to all programming vendors -- regardless of vertical integration. Those MVPD commenters compete with cable operators and claim to have been denied access to some programming from vendors that are not vertically integrated with cable system operators. Certain MVPDs allege that large MSOs exert pressure on non-vertically-integrated programming vendors to provide exclusivity to cable operators in exchange for carriage on their systems. 180. Since these comments were filed, the Commission has amended its program carriage rules to provide standing to MVPDs to file complaints alleging that cable operators have coerced programmers, whether vertically-integrated or not, into granting exclusivity to their competitors. The Commission concluded that coerced programmers might not file complaints because of the potential for damage to their future business relationships with the MSOs that coerced them. The Commission wrote that the mere threat of potential complaints by competing distributors should provide an added check on anticompetitive behavior by MSOs with respect to their negotiation of carriage agreements. The Commission will continue to monitor this situation to determine whether exclusivity agreements granted by services that are not vertically integrated have significant anticompetitive effects. 181. Access to Programming not Delivered by Satellite. Liberty Cable contends that the fact that the program access provisions of the 1992 Cable Act only apply to satellite- delivered programming restricts its ability to obtain attractive, desirable programming that is delivered by other means, and thus impedes its ability to compete with cable competitors who control or otherwise have access to such programming. Liberty Cable further predicts that, unless corrected, this problem will grow in the future because vertically-integrated programming vendors will have the incentive to modify the distribution of their programming, using fiber optics or other non-satellite means, in order to evade application of the program access requirements. 182. Time Warner disputes this concern, stating that satellite transmission remains the most effective method for distributing programming. NCTA argues that the program access provisions were intended to apply to popular, nationally-distributed and satellite- delivered basic and premium services, which arguably are vital to the success of MVPD competitors that use alternative technologies, and were not intended to affect unique, locally- originated programming. NCTA contends that forcing vertically-integrated programmers to provide such programming to competitors of cable system operators affiliated with them would create a strong disincentive to the development of costly and risky ventures like local news programming. The Commission will monitor industry conduct involving programming services that are not delivered via satellite transmission. 183. Alleged Price Discrimination with Respect to HSD Programming Distributors. NRTC and CSS contend that price discrimination continues to be a significant problem for HSD distributors, which allegedly must often pay prices two to five times higher than those charged to comparable cable operators. The programming vendors that filed comments, however, respond that the 1992 Cable Act permits differential pricing with respect to HSD packager-distributors because there are additional costs and services associated with serving such distributors. When it addressed this issue in a prior proceeding, the Commission agreed with the programmers' argument, writing that: service to HSD distributors may be more costly than service to others using different delivery systems such as cable operators, as additional costs are often incurred for advertising expenses, copyright fees, customer service, DBS Authorization Center charges and signal security. The record indicates that these cost differences are particularly evident when providing program services to HSD distributors who do not provide a complete distribution path to individual subscribers. Accordingly, the Commission recognized that pricing differentials with respect to HSD distributors may be justified. The Commission said, however, that it could only determine whether particular cost differentials were justified on a case-by-case basis. 184. In this proceeding, CSS submitted a table showing that the prices charged to HSD distributors for many popular programming services remain significantly higher than listed prices charged to cable operators, with the differentials ranging from 114% to 490% higher for HSD distributors. Other commenters argue that the data in that table are inaccurate, outdated and, in some instances, unverifiable. In its reply comments, HBO stated that counsel for CSS acknowledged in a meeting with HBO's counsel that information in the table was erroneous. The Commission declines to evaluate such data in this proceeding. Rather, such data can best be assessed in the context of individual program access complaints brought pursuant to the Commission's rules. 185. Other Alleged Discrimination Against HSD Packagers. Certain commenters allege that programming vendors discriminate against MVPDs that use specific technologies other than cable through the use of subscriber penetration level requirements, program offering requirements (service must be sold in every package offered by the HSD distributor to a customer), or tier placement requirements associated with lower rates. The only programming vendor to address those contentions in this proceeding was Comedy Partners, which contends that it offers the same rates for high subscriber penetration and overall distribution regardless of the delivery technology used by the distributor. The record is insufficient for the Commission to determine whether discrimination, is in fact, occurring with respect to penetration level requirements, tier placement requirements or service offering requirements. Those issues are best resolved in the context of specific adjudications. 186. Filing of Rate Information. Certain commenters request that the Commission require programming vendors to file rate information with the Commission. In the Program Access Report & Order, however, the Commission concluded that a requirement mandating all programming vendors to file rate cards or other rate information would impose an excessive administrative burden on the Commission and would pose difficult questions of confidentiality. The Commission also stated that: to the extent that parties have shown that standard "rate cards" generally do not exist, we believe that a filing requirement would impose an excessive constraint on vendors -- thus increasing the possibility of limiting the sale of programming -- and could diminish competitive pricing for multichannel programming through a standardization of higher programming rates as vendors become more aware of the pricing practices by competitors. b. Commission Rules Promulgated to Assure Diversity in Programming 187. The Commission's channel occupancy rules place a forty-percent limit on the number of channels that a vertically-integrated cable system may devote to video programmers in which the system operator has an attributable interest. In promulgating these rules, the Commission decided to: (1) calculate the forty percent limit from all "activated" channels; (2) measure "attributable interest" in a manner similar to the cable cross-ownership rules; (3) count each channel devoted to vertically-integrated pay and multiplexed services in the forty- percent limitation; (4) exempt local and regional programming from the limit; (5) apply the channel occupancy limits only to the first seventy-five channels of a cable system; and (6) apply the channel occupancy limits even to cable systems subject to "effective competition." 188. While these channel occupancy rules are in effect, the rules are currently under reconsideration by the Commission. Petitioners in the reconsideration proceeding have requested that the Commission, inter alia, lower the 40% channel occupancy limit and change the method by which the limit is calculated. A petition from Bell Atlantic requests that the Commission exempt systems under "effective competition" from the channel occupancy limits. 189. Currently, systems that exceeded the forty-percent limit as of December 4, 1992 are "grandfathered" and those operators are not required to delete attributable video programming services in order to comply with the limit. Instead, the Commission requires that once additional capacity becomes available on such a system (either through system upgrades or programming deletions), the cable operator must fill this additional capacity with video programming from unattributable programming vendors until it is in full compliance with the channel occupancy rules. To enforce the channel occupancy rules, cable system operators are required to maintain records regarding the nature and extent of their attributable interests in and carriage of video programming services, and the Commission welcomes monitoring by local franchise authorities of compliance within their franchise areas. 190. The Commission has not received any complaints alleging violations of its channel occupancy rules or petitions requesting that the restrictions be waived. That silence, ten months after the rules took effect, is a strong indication that there are no significant violations of the rules and that the rules are not unduly restricting the ability of vertically- integrated MSOs to deliver programming to their customers. However, the Commission does not have a sufficient record to determine whether cable systems exclude affiliated programming services because of the rules. Nor is there a sufficient record to address whether the channel occupancy limits have influenced investment of cable MSOs in programming, or whether unaffiliated programming vendors have benefitted from the limits. 3. Conclusions 191. In sum, it appears that the state of vertical integration in the cable industry has not altered significantly since 1990. Cable operators continue to invest in existing and new programming services. 192. The Commission's program access rules and its decisions applying those rules have given competing MVPDs access to programming produced by programmers that are affiliated with cable system operators. The Commission does not find it necessary to make any specific recommendations that Congress amend the program access provisions at this time. Nevertheless, the Commission will continue to monitor the marketplace, and will also rely on MVPDs competing in the marketplace to advise the Commission of further difficulties they encounter in obtaining programming, and the effect of those difficulties on their ability to compete. 193. The Commission has not received sufficient information in this proceeding to enable it to evaluate fully the impact of the vertical ownership rules, and will continue to monitor the impact of those structural limitations. C. Nature of Technical Changes Affecting Cable Systems 194. As discussed in earlier sections of the Report, aspects of industry structure, such as horizontal concentration and vertical integration, might affect competition between cable operators and competing distributors. However, industry structure is not a static concept. Therefore, as historically has been the case in other industries, technological change, whether evolutionary or revolutionary, can directly affect the competitive viability of firms using existing technologies, and has the potential to alter dramatically both industry structure and the overall competitive environment. 195. Telecommunications technologies, including those used in the distribution of video programming, are evolving rapidly. For example, technologies used to transmit voice, video and data are crossing the boundaries that have traditionally separated information distributors. Moreover, the cable industry and competing information distributors are in the midst of deploying new and improved transmission systems, and are projecting the near-term introduction of new and innovative services, that are presently unavailable to consumers, or are only available on an experimental basis. Those changes have the potential to exert a major influence on industry structure, and will affect the sustainability of competition with incumbent cable systems from MVPDs that use technologies other than cable. 196. Developments in system architecture may affect industry structure and the extent of competition. Different distribution media -- copper wire, coaxial cable, optical fiber, terrestrial microwave and satellites -- all differ in their information carrying capacity. Consequently, if technological breakthroughs allow one type of transmission system to increase capacity significantly, that technology may become more advantageous than other technologies. In such a case, the transmission systems using that technology may gain competitive advantages over systems that use other technologies. 197. For example, as companies seek to deliver more information, whether it be voice, video or data, through different transmission media, various compression and modulation techniques are used to fit the information within the media, and various switching techniques are used to enhance their ability to deliver the information to end users. Notwithstanding the benefits of increased network capacity, efficiency and functionality that are gained through various modulation, compression, multiplexing and switching techniques, many of these new technologies are designed in such way as to work most efficiently within a particular transmission medium, or with a particular transmission mode. Consequently, architectural design issues are affected by the various methods and technologies used for integrating and transmitting voice, video and data over the same network. 198. However, transmission capacity is not the sole consideration that influences the deployment and utilization of new technologies. Cost may critically influence which technologies win broad consumer acceptance, and which providers thrive in the new communications landscape. The deployment of fiber optic technology is an important example. Fiber optic wiring is often touted for its advantages of high capacity and low maintenance, and it is being widely deployed by cable operators and telephone companies. Cable operators and LECs have both expressed interest in bringing fiber closer to subscribers' homes. Some published reports suggest that the cost of fiber has fallen to the point where it may be economically installed for all but the last mile of network rebuilds and new construction. Others contend that while installation of fiber as part of a hybrid fiber-coaxial architecture is economical, deployment of fiber to the curb or to the home is still prohibitively expensive, and cost considerations associated with how far fiber is deployed into a network may have important competitive consequences. 199. Finally, a number of other interrelated architecture issues exist, which may impact the competitive landscape, including interconnection, consumer interface, and standards. The ability of the public to access, and interact with, the communications networks through modems or converter boxes -- the so-called on- and off-ramps of the national information superhighway -- is an important competitive issue because it visibly manifests the issues of interoperability, interconnectivity and compatibility. The issue of standards, which could impact interoperability, implicates the issue of open versus proprietary architectures. The company (and industry) that captures the lead in these debates may have a significant competitive advantage over other information providers. Such an advantage could potentially be extended into competitive advantages in other areas where interoperability and compatibility are desired. 200. The foregoing discussion suggests that it is too soon to draw any conclusions regarding the ongoing dynamics of technological change that permeate the telecommunications industry today. Nevertheless, significant issues that may have a dramatic effect on how competition develops in the delivered multichannel video programming industry are coming into focus. The Commission's ongoing review of such issues will be essential to the formulation of public policies for video distribution markets that will provide consumers with early access to the remarkable advantages that such technologies seem to promise. V. STATUS OF COMPETITION IN THE MARKET FOR THE DELIVERY OF VIDEO PROGRAMMING A. Extent of Competition and Assessment of Market Performance 1. Overview 201. The Commission finds in this Report that cable television remains the dominant medium for providing consumers with multichannel video programming. Most local markets for the distribution of multichannel video programming are highly concentrated, and for most consumers, cable television is the only provider of multichannel video programming. There are presently only a few scattered areas of the country where the local cable operator faces direct competition from an overbuilder. Moreover, providers using alternative technologies have not yet reached the subscribership levels necessary for the Commission to find the existence of vigorous rivalry in the market for multichannel video distribution. Relative subscriber levels for the cable industry and competing distribution technologies, to the extent available, are shown in Table 5.1 below. TABLE 5.1 Estimated Subscribership of Various Video Programming Distribution Systems (in millions) SYSTEM 1990 1991 1992 1993 CURRENT CABLE (mil) 51.7 53.4 55.2 57.4 57.9 HSD .7 .8 1.0 1.6 2.0 MMDS .3 .2 .3 .4 .5 SMATV 1.0 OVERBUILD 1.3 n/a PRIMESTAR .1 DIRECTV/ USSB n/a VDT none LMDS n/a n/a = not available. Shares for alternative distribution technologies include areas not passed by cable. 202. The dominance of cable television in local markets may be enhanced by horizontal concentration of cable MSOs nationwide. This Report finds that horizontal concentration among the largest cable MSOs has increased only modestly since the time of the 1990 Cable Report. The Commission notes, however, that there have been several proposed transactions in 1994, most notably, TCI-TeleCable, Cox-Times Mirror, Comcast-Maclean Hunter, and Time Warner-Newhouse, that will, if consumated, involve the largest MSOs acquiring control over a number of additional cable systems. In addition, MSOs appear to be creating regional "clusters" of cable systems and franchises. If those trends persist, the cable television industry will become increasingly concentrated nationally and regionally over the next few years. In addition, MSOs continue to invest in video programming vendors. The Commission anticipates that such investment will continue, and that the Commission's program access and carriage rules remain necessary to prevent the potential abuses of such investment. 203. In the longer term, increased rivalry in the market for delivered multichannel video programming should result in lower prices relative to present cable rates, and in a substantially broadened array of programming options for increasingly specialized audiences. In addition, consumers should receive more pricing options. Such rivalry may also be expected to provide a stimulus to more rapid development of new technologies and product innovation. At present, market performance in local cable markets does not yet reflect the benefits of this competitive rivalry. Therefore, lowering barriers to entry is likely to lead to significant gains in consumer welfare. 2. Market Performance Indicators 204. The effectiveness of the existing level of competition at improving market performance, i.e., the extent to which a given market satisfies consumer demand in the least costly manner, may be assessed using several market performance indicators. Among various alternative indicators of market performance, emphasis is placed on measures that provide insight concerning the current relationship of cable rates to the cost of production. Empirical measures of market power provide such insight, and are discussed in the following paragraphs and Appendix H. Other indicators of market performance, such as the price effects of overbuild competition and improvements in cable services, are also considered. a. Pricing Above Competitive Levels Indicates Market Power 205. The following discussion emphasizes on two key indicators that suggest that cable systems are currently exercising market power: (1) the q ratio, a ratio of the market value of cable assets to the replacement cost of such assets; and (2) pricing analyses showing that prices in monopolized cable distribution markets exceed those in similar cable markets where there exist cable system competitors. If a firm can set its prices above its costs and earn excess economic profits for a sustained period of time, then the firm possesses market power. 206. In the past, the Commission has looked to the q ratio as an indicator of market power. Under conditions of perfect competition, potential buyers of the assets of a competitive firm which, by definition, does not earn excess economic profits, are unwilling to pay much more than the reproduction cost of the firm's tangible assets. As a result, the market value of a firm selling in markets that approximate the conditions of perfect competition is roughly equal to the reproduction cost of the firm's tangible assets. Given this logic, the q ratio of a firm supplying competitive markets and earning no excess economic profits over the longer term should equal one, i.e., the market value of a firm's assets should equal their replacement value. 207. Alternatively, q ratios well in excess of one suggest that a firm, or a collection of firms in an industry, may be earning excess profits. Such a result is consistent with the presence and exercise of market power, inasmuch as excess profits are generated by price-cost margins that are greater than what may be required simply to recover the total cost of production in the presence of economies of scale. If a q ratio is greater than one, then another firm would find it profitable to enter the market. Such entry would increase market supply, force prices and profits down towards a competitive level, and hence, reduce the market value of the incumbent firm or firms. When the q ratio reached one, entry would no longer be profitable. 208. Professor Paul MacAvoy, currently Dean of the School of Organization and Management at Yale University, submitted q ratio estimates in connection with the 1990 Cable Report. His "best estimate" of the q ratio for the cable industry was 4.3 for September 30, 1989. In connection with this Report, the Commission calculated some q ratios based on more recent data. The calculations are useful not only because they provide some indication of the current level of market power in the cable industry, but also because, with some qualifications, they permit a comparison of the market power levels in 1989 with those of more recent times. 209. There are two primary techniques for calculating market value, both of which were used by the Commission in the q ratio calculations that were prepared for this Report. One, which MacAvoy refers to as "public" market value, involves the calculation of the sum of a firm's liabilities and the value of its outstanding stock. In order to utilize this technique, it is necessary to have a sample of firms that are involved only in cable television delivery. MacAvoy identified five such firms for 1989. The Commission was able to identify four such firms for 1993, only two of which are also in the MacAvoy sample. The second technique, which MacAvoy labels "private" market value, involves the calculation of the average (weighted by number of subscribers) of per subscriber selling prices of cable companies. In this second method, only cash transactions are included, because it is difficult to determine market values for transactions that include non-cash components. 210. There are also two primary techniques for calculating replacement costs. One is based solely on financial data, and consists of an estimate of the adjusted book value of tangible assets ("net plant"). The figure for net plant is adjusted for inflation, and then added to other tangible assets. The second method uses other tangible assets from financial accounts, but substitutes a construction cost estimate for net plant. The estimated cost of new construction per subscriber is depreciated by the average age of cable plant, and other tangible assets are added to calculate replacement cost. Once again, the financial data must come from firms that are involved only in cable television delivery. Because the bulk of tangible assets tend to be accounted for by net plant, the financial data play a smaller role in estimates that utilize construction costs. In calculating q ratios based on replacement costs that are estimated from construction costs per subscriber, MacAvoy chose the median of several construction cost estimates. 211. The following table presents five q ratio calculations based on current data, and also sets forth the MacAvoy calculations to which they are most comparable. As explained in Appendix I, none of the current calculations are perfectly comparable to the MacAvoy calculations. However, the comparisons are at least suggestive of possible trends in cable market power. Appendix I contains a more detailed discussion of these calculations. TABLE 5.2: Estimated q Ratios for the Cable Industry Method Current q Estimates MacAvoy 1989 q Estimates Public Market Value/Adjusted Book Value (Current, four firms; MacAvoy five firms) 4.47 4.30 Public Market Value/Adjusted Book Value (for two firms common to both samples) 4.52 4.17 Public Market Value/Median Construction Cost (Current, four firms; MacAvoy five firms) 5.23 4.56 Private Market Value (1993 transactions)/Median Construction Cost 4.11 6.2 Private Market Value (some 1994 transactions)/Median Construction Cost 3.95 6.2 Source: See Appendix I. 212. Even with the caveats enumerated in Appendix I, the current q ratios suggest that, overall, cable television operators possess substantial market power. The comparisons between 1989 and 1993/94 are inconclusive, however, allowing both the inference that market power may be increasing, based on the calculation that uses public market values, and the inference that market power may be decreasing, which is derived from the private market value calculation. 213. Price Effects Shown by Overbuild Competition and the Commission's "Competitive Price Differential." The Commission received significantly more reliable pricing information in this proceeding than was available at the time of the 1990 Cable Report. The exercise of market power (pricing well in excess of marginal cost) in local markets is shown by (1) evidence concerning price changes in local cable markets following the entry of second cable companies, and (2) the Commission's cable rate reregulation orders, in which it estimated a "competitive price differential" by focusing primarily on the difference between prices charged by monopoly cable systems and those facing direct competition. 214. A number of empirical studies have addressed the effects of two-firm (duopoly) competition in cable television markets using published or survey data. The focus of those studies has been primarily on how such rivalry affects prices. A simple test for the presence of competitive price effects is to compare prices in monopoly and duopoly cable markets. Those studies consistently show that prices in duopoly markets are significantly lower than in monopoly markets. For example, in a 1987 survey, the price of a package including basic service plus one premium service was found to be 23.5% lower in competitive cable markets than in monopolized markets. More recently, a 1992 study found that basic rates were 21.9% lower in competitive markets than in monopolized markets. 215. While studies using survey data show significant price differentials in duopoly cable markets, the survey approach fails to take into account the effects of local cost and demand conditions. For example, no consideration is given to per capita income in the cable market. If cable demand is sensitive to income levels, then ignoring that effect "biases" the estimate of the price effect of competition. Furthermore, the survey method fails to account for the number of available channels, the cable system size, regional wage rates, and other factors that are important determinants of the supply and demand for cable service. 216. An improved estimate of the effects of entry can be produced by using a methodology that accounts for demand and cost differences across markets. A number of empirical studies have employed econometric techniques to estimate a competitive differential that is adjusted for demand and cost factors. Those studies support the findings of the more simple survey approach, and find cable rates in competitive markets to be significantly lower than rates in monopolized cable markets, even when other factors are held constant. For example, adjusting for a number of factors such as system size and the number and type of channels available, Stanford Levin and John Meisel found that cable rates are, on average, $3.33 lower in competitive cable markets than in monopolized markets. In a far more sophisticated study, Richard Beil, et al. estimated a competitive differential of $3.85, other things remaining constant, which amounts to a savings of over twnety percent for basic cable service. That study also found that systems in competitive markets priced premium services $1.10 lower than did monopoly systems. 217. A few recent studies, including the Commission's re-calculation of the competitive differential for the purpose of rate regulation, have improved the measure of competitive price used in their statistical models to account for differences in the extent of competition across competitive cable markets. Those studies measure competition as the degree of overlap between competing systems. The application of this measure carries with it the assumption that competitive prices in cable markets can vary depending on whether the overbuilder competes over the entire market or only overlaps with the incumbent in part of the market. 218. When it re-calculated the competitive differential, the Commission adopted an overlap measure of competition, where competition is measured by the percent of the franchise market that both rivals serve. Adjusting for a number of variables including firm size, the number of available channels, and income, the Commission's analysis estimated a sixteen percent competitive differential, i.e., that prices in areas served by two cable systems were sixteen-percent lower than prices in monopolized areas. That differential, along with the differentials for other systems subject to effective competition as defined in the 1992 Cable Act, formed the basis for the rate rollback in the 1994 Rate Report & Order. Using the same measure of competition, a recent econometric study not only adjusted for demand and cost differences, but also accounted for other possible biases that might distort empirical estimates of the price difference between monopoly and duopoly cable distribution markets. That study produced the estimate that a completely overbuilt system will have rates approximately twenty-percent lower than a monopoly cable system, holding other things constant. The study allowed for demand elasticity estimates for both monopoly cable systems and systems in duopoly markets. The demand curve for firms facing direct competition was found to be more elastic than the monopolist's demand curve, implying that a cable system's market power is constrained by overbuild competition. 219. Excess Profits as an Inducement for Competitive Entry. New firms are likely to enter an industry if current and anticipated profits are supracompetitive. Large investments by competitors using alternative technologies, such as MMDS and DBS, and the history of attempted entry by overbuilding, suggest that potential profits in the cable market are substantial, a perception that is consistent with the foregoing discussion of pricing in local cable markets. The proposed entry into video distribution by local telephone companies is also noteworthy, since the high cost of upgrading telephone networks in order to allow video distribution might not be justified if LECs did not believe that there was potential profit in video packaging and distribution. There may be other explanations for the interest in competing with the cable operators. The prospective entrants may believe that they can provide services at lower costs than the incumbents, or they may believe that the market demand for additional services that can be supplied with cable programming is large enough to support additional entry. Therefore, while interest in entry in this market may suggest that prices exceed costs, such evidence taken alone is not conclusive with respect to the potential profitability of additional entry in local cable markets. b. Other Indicia of Market Performance 220. The finding of an exercise of substantial market power in local markets implies a loss of economic efficiency. Market performance and consumer welfare are adversely affected by such losses. Other data suggest, however, that to some extent cable operators may be responding to consumer preferences and the resulting growth in demand for video programming. In this proceeding, the Commission has found that the demand for the multichannel programming services provided by local cable systems has continued to grow since 1990. The cable industry has responded positively to this growth in demand by increasing the number of homes that could receive cable service ("homes passed") to 92.9 million in 1993, an increase of 8% over the number of homes passed in 1990. Actual demand for cable services grew from 51.7 million households in 1990 to 57.4 million households in 1993. Accordingly, nearly 60% of all television households in the United States subscribed to cable services in 1993, up from 55.4% in 1990. Moreover, mean cable penetration (the fraction of households with access to cable services that actually subscribe) increased from 60.1% to 61.8% from 1990 to 1993. 221. Broad consumer acceptance of the video programming services offered by cable systems is reflected in the growth in cable industry revenues from $17.86 billion in 1990 to $22.94 billion in 1993. That growth in revenues represents a greater than 28% increase from 1990 through 1993. As is more fully discussed above in section II, such revenue growth clearly suggests that consumers find the growing array of programming services offered by cable systems responsive to their preferences for such programming services. 222. Clearly, the cable industry continues to respond positively to the overall growth in consumer demand for more services and improved programming choices. Yet, growth in output has been accompanied by non-competitive pricing of services that may have suppressed subscribership, relative to that which would otherwise prevail if basic service rates were lower. As shown in Appendix H, the demand for basic cable service tends to be responsive to reductions in price (i.e., demand is price elastic) at currently observed price levels. Therefore, price reductions would be expected to stimulate an increase in penetration levels while improving the net benefits that consumers derive from cable services. Accordingly, there remain today substantial opportunities for improving consumer welfare. 223. Other indicators of economic efficiency as a criterion of market performance include measures of technological change in production, product innovation, and industry expenditures on research and development. Unfortunately, useful data on such indicators of economic efficiency in the cable industry are limited. As a result, the Commission does not possess sufficient data for a complete empirical assessment of whether the cable industry is performing well by enhancing consumer welfare. Nevertheless, evidence developed in this Report facilitates a qualitative assessment of these indicators of industry performance. 224. Although difficult to measure and assess at present, the quality of multichannel video programming services offered by cable systems appears to have improved since 1990, when measured in terms of the number of channels available to subscribers. The record in this proceeding demonstrates that cable systems with the capacity for providing thirty or more channels accounted for over 77% of all cable systems for which information was available in 1993. That percentage represents an increase from 67% in 1990. Growth in the number of programming networks is another rough indicator of improvements in the quality of cable service. The record reveals that the total number of networks increased by over 51% from 70 in 1990, to 106 at present. Those improvements in service quality should permit a closer alignment between diverse consumer tastes for video programming and the ability of cable systems to meet such consumer demand. Improved matching of consumer demand with the available supply of video programming through time represents an improvement in economic efficiency. 225. Industry investment expenditures represent a commitment by firms to meet current and future growth in consumer demand while improving both product quality and variety. Investment spending is the vehicle, therefore, for implementing improvements in the technologies of production, and for implementing product or service innovations. The record before the Commission shows that total cable industry capital investment has fluctuated around $3 billion annually since 1990, but is projected to increase to $3.8 billion in 1994. Such spending reflects a commitment to implement technical change that will increase the quantity and improve the quality of cable service in the future. 226. As described in Section IV.C, supra, the ongoing installation of fiber optic distribution facilities in local cable systems will dramatically increase transmission capacity while expanding the number of services that cable systems may eventually offer their subscribers. Moreover, the cable industry supports a substantial research and development program through Cable Labs. That industry research effort may well result in a new cable network structure incorporating technical changes that will improve the quality and variety of services offered to subscribers over the longer term. c. Conclusion 227. Current market performance in the multichannel video programming distribution industry, when assessed in terms of several indicators of economic efficiency, is mixed. While the industry is responsive to growth in consumer demand, the output is supplied to consumers at prices that often imply substantial losses in economic efficiency. The industry continues to invest in the deployment of improved video distribution facilities, which should offer the consumer expanded video programming options. The industry also invests in research and development, which should improve the capabilities and performance of local cable networks and services in the future. The willingness of new entrants to invest substantial resources in competition with the incumbent cable systems suggests, however, that there exist further opportunities for improved market performance. 3. Existing and Potential Impediments to Competition 228. In this Section of the Report, the Commission addresses certain existing and potential impediments to competitive entry that may have a dampening effect on the extent of competition in the video programming delivery market. In particular, the Report addresses impediments flowing from the strategic behavior of incumbent firms, legal restrictions, and technological bottlenecks. As will be discussed, in certain instances, those impediments may block potential entrants from entering the market altogether. More commonly, however, the impediments serve to increase the cost of a rival's entry, and hence its cost of production as compared with that of incumbent firms. a. Strategic Behavior to Deter Competitive Entry 229. The cost of constructing a cable distribution network may be viewed as a sunk cost, i.e., an operator's investment in its cable plant cannot typically be physically redeployed to some other profitable use if operation of the system were to become unprofitable. The existence of those sunk costs creates strong incentives for the incumbent cable operator to engage in strategic behavior designed to protect that investment. While such behavior may take the form of vigorous competition, which enhances consumer welfare, cable operators also have the incentive to engage in strategic behavior designed to deter entry by potential rivals. 230. Access to Program Supply. Under certain conditions, agreements that restrict a supplier's right to deal with competitors of a dominant downstream firm can have the effects of raising its rivals' costs by restraining the availability of needed inputs and of decreasing the demand for programming. Through such exclusionary rights agreements, a dominant firm can deter competitive entry, and retain the power to raise prices in its output market. 231. One example of such behavior in the cable industry involves efforts by cable operators to restrict the supply of programming to suppliers that use alternative distribution technologies. As Congress recognized in enacting the program access provisions of the 1992 Cable Act, by controlling access to programming supply, cable operators were able to inhibit competitive entry and maintain their monopolies over the distribution of programming in most markets. In this proceeding, the Commission has found that following the implementation of the program access provisions of the 1992 Act, the cable industry's use of program availability as a means of deterring entry has, to a large extent, abated. The record also reflects a number of continuing concerns over potential strategic behavior by cable operators involving access to programming that are not within the purview of the current regulatory scheme. 232. In particular, the program access provisions of the statute only apply to "satellite cable programming." Therefore, as discussed above, programming services distributed by any other means are not subject to the program access requirements. As a result, some commenters raise the possibility that cable operators may have the incentive and ability to engage in strategic behavior designed to shift programming from satellite distribution to fiber optic or some other form of terrestrial distribution, thereby removing the programming from the purview of the program access provisions. In addition, regional clustering of systems combined with a system's ownership of one or more regional programming networks, may create additional incentives for the operator to engage in strategies designed to deny competing distributors access to its programming. One such strategy could include shifting regional programming to terrestrial distribution to facilitate denial of the programming to competitors. 233. A second area in which commenters argue that cable operators may have the continued ability to engage in strategic behavior with respect to program access matters involves the program access provision's limitation to programming supplied by vertically- integrated programming vendors, i.e, vendors in which cable operators have an attributable interest. Thus, commenters have suggested that cable operators, using their buying power over programmers, can extract concessions from non-vertically integrated programmers that raise rival operators' costs of obtaining programming or deny them access to programming altogether. Moreover, as the industry becomes further concentrated, the potential for collusion among operators jointly to pressure programmers to adopt what may be broadly thought of as pro-cable distribution policies, may be further enhanced. 234. To a certain extent, the potential for such conduct may have been limited by the Commission's recent decision amending its program carriage (as distinguished from the program access) rules. The Commission has amended its rules to provide standing to MVPDs to file a complaint alleging that a cable operator has coerced a programmer, whether affiliated or not, into granting exclusivity to the cable operator. 235. Other Entry Deterring Behavior. The record also reflects several other types of strategic behavior allegedly engaged in by cable operators that may have the effect of raising rivals' costs and thereby deterring competitive entry. For example, one SMATV commenter complains that a competing cable operator purposely impedes subscriber changeovers by failing to disconnect subscribers in a timely manner and refuses to coordinate the process with the alternative provider. 236. In addition, there are allegations in the record of cable operators engaging in conduct that may impede the ability of MMDS operators to acquire needed licenses. In particular, it is claimed that cable operators have induced ITFS licensees not to lease their excess capacity to wireless cable operators. 237. A final type of strategic behavior that may serve to delay entry and raise rivals' costs is the aggressive use of the legal process. For example, TCI filed a civil action seeking to overturn the award of a second franchise to Fibervision by the state of Connecticut. At the time the suit was filed one published report suggested that the suit could delay Fibervision's construction schedule and complicate its ability to raise financing. That suit has recently been resolved in Fibervision's favor. In a second situation, Warner Cable, a predecessor to Time Warner, filed various legal challenges which delayed the planned construction by the city of Niceville, Florida of a municipal overbuild. In one of these cases, the Supreme Court of the State of Florida rejected Warner's challenge to a lower court order authorizing the city to issue revenue bonds to construct the municipal overbuild. In a second case, the Eleventh Circuit affirmed the lower court's rejection of Warner Cable's challenge to the municipal overbuild. Despite these court victories, one published report noted that Niceville still had not begun construction of its system as of 1993. 238. The filing of sham litigation has long been recognized as a means of raising rivals' costs that is actionable under the antitrust laws. On the other hand, such claims may have a legitimate basis (beyond deterring entry), and, therefore, constitute protected conduct. For example, Time Warner commented that actions it brought against Niceville to enjoin construction of a municipal overbuild were not a "delaying tactic," as asserted by Bell Atlantic. Rather, Time Warner claims that it initiated the litigation to vindicate its due process and First Amendment rights. b. Regulatory Impediments 239. The record in this proceeding also reflects various regulatory impediments to competitive entry. One regulatory impediment to SMATV and wireless entry arises from the Communications Act's definition of a "cable system." As discussed herein, a SMATV or wireless system that connects separately owned buildings with a wire (even if the wire does not cross a public right-of-way) is deemed a "cable system" under the Communications Act and would be required to obtain a local franchise. As an alternative to submitting to the franchising process, operators either use more-expensive microwave relays to distribute between adjacent buildings or forego service to the buildings altogether. 240. The record also reflects federal statutory schemes that prevent competitive entry altogether, or may prevent the most efficient form of entry. More importantly, under the Communications Act, LECs are prohibited from providing video programming directly to subscribers in their service areas. The Commission has established a VDT model by which LECs can operate broadband video distribution systems on a common carrier basis, consistent with this cable-telco ownership ban. However, conditioning LEC entry on the provision of common carrier services may affect the manner in which LECs can most efficiently enter the market. For this reason, the Commission continues to advocate repeal of the cable-telco cross- ownership ban, subject to the imposition of appropriate safeguards to prevent cross- subsidization from local exchange services. 241. Various state laws may also serve to impede competitive entry. For example, a recently enacted California statute allows municipalities to require video programming distributors to undertake various actions in cities in which they offer video programming. That requirement will potentially impose significant costs on alternative distributors. Similarly, despite limited preemption by the Commission, local zoning regulations may inhibit competition from direct-to-home programming distributors, by preventing home users from installing HSDs and smaller DBS dishes. c. Potential Technological Bottlenecks 242. The creation of technological bottlenecks in the telecommunications industry, historically, has been of great concern to the Commission. The record in this proceeding reflects a variety of potential bottlenecks, some as old as the industry itself, and others related to emerging technological developments. 243. In particular, concerns have recently reemerged with respect to utility poles as a potential bottleneck where cable operators themselves might be suffering competitive harm. Many cable operators lease space on utility poles in order to string wires and deliver programming. The contract between the cable operator and the owner of the pole is known as a "pole attachment agreement." "[A]s a solution to a perceived danger of anticompetitive practices by utilities in connection with cable television service," Congress passed the Pole Attachments Act of 1978, which directs the Commission, with certain exceptions, to ensure that the "rates, terms and conditions [of such agreements] are just and reasonable . . . ." At this juncture, the Commission notes that pole attachment is an area that could affect the status of competition in the delivered video programming market and may merit Commission attention in the future. 244. The Commission notes that MSOs are currently investing in digital compression and encryption technologies, which could impact the manner in which "raw" video programming is distributed via satellite nationally, and possibly create a technological bottleneck to competing distribution media. For example, two commenters have expressed concern that TCI's National Digital Television Center might be used to block access to programming by competing MVPDs. That facility would convert the analog feeds of participating programmers into a compressed and encrypted digital format and then uplink the feed to satellites for distribution to cable systems and home satellite users. Commenters appear to be concerned that, over time, access to the Digital Television Center may become necessary in order to gain access to programming that is encrypted through that facility. 245. Finally, as the cable industry converts to digital technology and two-way communications, issues concerning network architecture, standardization, and access may become important competitive issues as they have in the telephone industry. While this Reportprovides no analysis of the potential significance of such issues at this time, it is likely that such issues will require attention in future Reports. 4. Extent of Competition in the Multichannel Video Programming Distribution Market 246. Today, most local markets for multichannel video programming distribution services are supplied by monopoly cable systems. At present, competitive rivalry in most local multichannel video programming distribution markets is largely, often totally, insufficient to constrain the market power of incumbent cable systems. As the overbuild experience demonstrates, the entry of competitors to local cable systems over the coming months and years should exert a significant, favorable effect on market conduct and performance in local markets for multichannel video distribution services. Consequently, the outlook for improved market performance in multichannel video programming distribution markets as a consequence of increasing competitive rivalry remains promising. B. Future Considerations and Recommendations for Promoting Competition to Cable Systems 247. The Commission has, throughout this Report, identified several types of dominant firm strategic behavior, policy-relevant barriers to entry, and technological bottlenecks that could adversely affect performance in the multichannel video programming distribution market. The Commission has noted in this Report that several alternative distribution media are just now becoming operational and available to a significant number of consumers. In particular, the nation's first high-powered DBS operators, DirecTV/USSB, which project that there will be five to ten million households receiving DBS services by the end of the decade, have only become operational within the last six months. Moreover, LECs hope to make available networks that are capable of delivering video programming to over twenty million subscribers by the end of the decade. However, while numerous LECs are engaged in various trials of VDT service, such service has been authorized in only a single market. As a result, while the Commission believes that several specific reforms might improve market performance, most of the competitive issues raised in this Report will require ongoing monitoring as a more dynamic and competitive environment develops in this market. 248. The Commission's procedures for "effective competition" challenges to rate regulation are not designed to, and do not, provide enough information to monitor the extent of competitive entry on a nationwide scale. In the coming year, Commission staff will endeavor to find a mechanism to collect, interpret and monitor the growth of alternative distribution media so future Reports will be able to provide a more complete picture of the status of competition at both the local and national levels. 249. In particular, consistent with the 1992 Cable Act's policy of encouraging cable overbuilding, the Commission will continue to collect data and information regarding the extent of cable overbuilding and the competitive checks that overbuilds have on the pricing behavior of incumbent cable systems. 250. The Commission will also monitor whether undue delays in granting final determinations on overbuild franchise applications interfere with the effectiveness of Section 621 of the Communications Act, which prohibits a franchising authority from refusing to grant a competitive franchise. Section 621 provides an applicant with the right to appeal the denial of an application to the Commission, but only from the "final" decision or determination of a franchising authority. 251. In addition, the Commission will continue to monitor litigation involving the application of the Congressional ban on the granting of exclusive cable franchises to existing situations. The Commission believes that the approach of the Eleventh Circuit in Cox Cable Communications, Inc. v. United States correctly interprets the statute, but notes the inconsistent holding of the court in Jones Cable Partners v. City of Jamestown. If the holding of the Jones court gains approval in a United States Circuit Court of Appeals, the Commission will recommend that Congress revise Section 621 of the Communications Act to provide a clear expression of Congressional intent to have the provision apply to existing exclusive franchise agreements. 252. The Commission recommends that Congress consider modifying 47 U.S.C.  522(7)(B) so as to exclude from the definition of a "cable system" not only commonly- owned, but also separately-owned, dwellings interconnected by wires which do not cross public rights-of-way. Such a revision would promote the growth of wireless cable and SMATV systems as competitors to cable systems by substantially reducing the costs of expanding their systems. 253. Besides these specific proposals, however, there are several other issues of strategic behavior, barriers to entry, and technological bottlenecks that the Commission believes merit future study through this annual report process. Because this market is dynamic and evolving, the Commission anticipates that, to a certain extent, this series of reports will be a work in progress in which certain parts are continually updated and revised. 254. At present, the Commission expects the following issues to be among those covered in next year's and subsequent competition reports: (a) changes and trends in cable industry performance; (b) the status of competing technologies; (c) horizontal concentration of MSOs, cable operator ownership of other distribution technologies, and investments by firms outside the cable industry, such as LECs, in the cable industry; (d) vertical relationships between MVPDs and programming interests; and (e) emerging technological advances, such as digital compression and encryption, and their impact on the cost structure for providers of video programming, and the potential creation of barriers or "bottlenecks." Future reports will also continue to provide updated information concerning application of the program access and program carriage rules administered by the Commission, as well as continuing analyses of the evolution of contracting practices between programmers and MVPDs in response to those rules. Finally, the Commission will report information regarding the number and character of cable systems deemed to be in "effective competition," and therefore no longer subject to rate regulation. 255. Because of these recurring issues, the Commission stated in its NOI that "it may be desirable to establish more systematic reporting procedures," and requested the industry to comment on the methods the Commission might use in the future to gather information. In particular, the Commission requested comment on whether surveys or questionnaires of MVPDs and video programmers would be an appropriate method of updating the various tables attached to this Report; whether the Commission should institute annual reporting requirements for all or some MVPDs as a method of tracking and evaluating the development of competition in the video programming marketplace; and how information on vertical relationships between cable systems and video programmers (already maintained pursuant to 47 C.F.R.  76.504(e)) could be compiled and maintained for use by the Commission in these reports. The Commission also sought comments concerning whether the information compiled pursuant to the Primestar Consent Decrees should be made available to the Commission, and how the Commission could gather or examine proprietary or confidential data and protect information that is obtained. 256. Several commenters note that a majority of the basic information sought by the Commission generally is available through public sources, such as company reports filed with the Securities and Exchange Commission, and the publications of Paul Kagan Associates Inc., NCTA and SBCA. In addition, commenters state that the Commission will obtain pertinent information, such as data on industry pricing, through rate and program access complaints. The majority of the commenters oppose as burdensome the imposition of any additional mandatory reporting requirements. Several commenters also express concern about the collection of confidential and proprietary business information. Some commenters dispute whether the Commission even has the authority to impose such reporting requirements. In contrast, a few commenters favor some form of reporting requirements. 257. The Commission believes that Sections 19(f)(2) and 3(g) of the 1992 Cable Act, as well as its licensing authority and other sections of the Communications Act, provide a sufficient legal basis for the Commission to establish and impose reporting requirements with respect to MVPDs and vertically-integrated programming vendors. However, the Commission is sensitive to the concerns expressed by the cable industry and others regarding the imposition of additional and costly administrative burdens. The Commission also is sensitive to the concerns of the industry regarding proprietary and confidential information. 258. Consequently, at this time, the Commission will not recommend any additional reporting requirements to facilitate preparation of future competition Reports. At present, for its next report, the Commission intends to develop information through a new notice of inquiry and submitted comments, limited voluntary surveys, and publicly-available information from trade and industry sources. The Commission will also review information already filed with the Commission, such as information provided in rate and program access complaints. In addition, as described above, Commission staff will endeavor to find a mechanism other than certification challenges to determine the extent of effective competition to cable nationwide. 259. Consistent with the requirement that the Commission annually report to Congress on the status of competition, future reports will be submitted to Congress by November 15 of each subsequent year. VI. ADMINISTRATIVE MATTERS 260. This Report is issued pursuant to authority contained in Section 19(g) of the Cable Television Consumer Protection and Competition Act of 1992, 47 U.S.C.  548(g), and Sections 4(i) and 403 of the Communications Act of 1934, as amended, 47 U.S.C.  154(i), 403. 261. It is ORDERED that the Secretary shall send copies of this Report to the appropriate committees and subcommittees of the United States House of Representatives and the United States Senate. Federal Communications Commission William F. Caton Acting Secretary APPENDIX A Notice of Inquiry, Docket No. CS 94-48 Comments Date received 262. Bell Atlantic . . . . . . . . . . . . . . . . . . .(6/29/94) 263. BellSouth Telecommunications, Inc. . . . . . . . .(6/29/94) 264. CellularVision of New York, L.P. . . . . . . . . .(6/29/94) 265. Consumer Satellite Systems, Inc., Programmers Clearing House, Inc., and Satellite Receivers, Ltd. (6/29/94) 266. DirecTV, Inc. . . . . . . . . . . . . . . . . . .(6/29/94) 267. GTE Service Corporation . . . . . . . . . . . . . .(6/29/94) 268. Home Box Office . . . . . . . . . . . . . . . . . .(6/29/94) 269. Liberty Cable Company, Inc. . . . . . . . . . . . .(6/29/94) 270. Liberty Media Corporation . . . . . . . . . . . . .(6/29/94) 271. National Cable Television Association, Inc. . . . .(6/29/94) 272. National Rural Telecommunications Cooperative . . .(6/29/94) 273. NYNEX Telephone Companies . . . . . . . . . . . . .(6/29/94) 274. Peoples Choice TV Corporation . . . . . . . . . . .(6/29/94) 275. Primestar Partners, L.P. . . . . . . . . . . . . .(6/29/94) 276. Satellite Broadcasting and Communications Association of America (6/29/94) 277. Tele-Communications, Inc. . . . . . . . . . . . . .(6/29/94) 278. Time Warner Cable . . . . . . . . . . . . . . . . .(6/29/94) 279. Turner Broadcasting System, Inc. . . . . . . . . .(6/29/94) 280. US West Communications, Inc. . . . . . . . . . . .(6/29/94) 281. Wireless Cable Association International, Inc. . .(6/29/94) Reply Comments Date received 1. American Telecasting, Inc. . . . . . . . . . . . .(7/29/94) 2. Ameritech . . . . . . . . . . . . . . . . . . . . .(7/29/94) 3. Bell Atlantic . . . . . . . . . . . . . . . . . . .(7/29/94) 4. Comedy Partners . . . . . . . . . . . . . . . . . .(7/29/94) 5. Consumer Satellite Systems, Inc., Programmers Clearing House, Inc. and Satellite Receivers, Ltd. (7/29/94) 6. GTE Service Corporation . . . . . . . . . . . . . .(7/29/94) 7. Home Box Office . . . . . . . . . . . . . . . . . .(7/29/94) 8. Liberty Cable Company, Inc. . . . . . . . . . . . .(7/29/94) 9. National Cable Television Association, Inc. . . . .(7/29/94) 10. National Rural Telecommunications Cooperative . . .(7/29/94) 11. Netlink USA . . . . . . . . . . . . . . . . . . . .(7/29/94) 12. Primestar Partners, L.P. . . . . . . . . . . . . .(7/29/94) 13. Primetime 24 . . . . . . . . . . . . . . . . . . .(7/29/94) 14. Southern Satellite Systems, Inc . . . . . . . . . .(7/29/94) 15. Superstar Satellite Entertainment . . . . . . . . .(7/29/94) 16. Teledesic Corporation . . . . . . . . . . . . . . .(7/29/94) 17. Time Warner Cable . . . . . . . . . . . . . . . . .(7/29/94) 18. United States Satellite Broadcasting Company, Inc., Consolidated Comments and Reply Comments. . . . .(7/29/94) 19. Valuevision International, Inc. . . . . . . . . . .(7/29/94) 20. Viacom International Inc. . . . . . . . . . . . . .(7/29/94) 21. Wireless Cable Association International, Inc. . .(7/29/94) Miscellaneous Filings Date Received 1. Errata to NCTA's Comments filed June 29, 1994 (with attachments)(7/25/94) 2. Letter from Deborah C. Costlow, Esq. to Cable Services Bureau Staff(8/12/94) 3. Letter from Deborah C. Costlow, Esq. to Cable Services Bureau Staff(8/23/94) 4. USSB - Supplement to Consolidated Comments and Reply Comments (8/19/94) 5. NRTC Letter Response to USSB Supplement . . . . . .(9/02/94) 6. USSB Response to Commission Request . . . . . . . .(9/13/94) 7. DirecTV Letter Response to Commission Request . . .(9/12/94) Note: The Commission also received numerous letters in support of the NRTC's Comments in this proceeding. APPENDIX B GLOSSARY OF TECHNICAL TERMS AND ACRONYMS Asynchronous Digital Subscriber Line ("ADSL") - A technology that utilizes compression of digital video signals to enable existing copper twisted pairs to carry multiple, simultaneous high-speed services to the subscriber. Asynchronous Transfer Mode ("ATM") - An international standard set by the Consultative Committee on International Telegraph and Telephone ("CCITT") for high-speed broadband transport of packet-switched networks operating at specified digital transmission speeds. ATM switches facilitate efficient operation of networks transporting "bursts" of information that may include video signals. See Telecom Publishing Group, Telecom Lingo Guide 6 (6th ed. 1991). Broadband - A term used to describe any system capable of delivering multiple channels or services to its users. Broadband Switch - A term used to refer to a technology designed to route broadband signals through a transmission system. ATM is a type of broadband switch. Channel Service - A service whereby Local Exchange Carriers offer, on a common carrier basis, complete video transport services to cable operators from a cable system's headend to residential customers' premises. Telephone Company-Cable Television Cross-Ownership Rules, Sections 63.54-63.58, Further Notice of Proposed Rulemaking, First Report and Order and Second Further Notice of Inquiry  11, 7 FCC Rcd 300, 307 (1991). Fiber to the Curb ("FTTC") - A type of architecture involving the installation of fiber optic cable from the trunk through the distribution network to the curb. A curbside "vault" typically will serve a dozen homes. Fiber to the Home ("FTTH") - A type of architecture involving the installation of fiber optic cable throughout the network from the trunk to end-user premises. Fiber to the Node ("FTTN") - A type of architecture involving the installation of fiber optic cable from the trunk, through the distribution network, to the neighborhood or the node. Typically, a node will serve between 400 and 500 homes. Hybrid Fiber-Coax ("HFC") - A type of architecture involving the installation of fiber through part of the distribution network, with coaxial cable installed in the remainder of the network to the end-user. HFC architecture is generally used with either FTTC or FTTN, with coax replacing conventional copper wire to the end-user. Instructional Television Fixed Service ("ITFS") - A fixed microwave station operated by an educational organization and used mainly to transmit educational information to fixed receiving stations. Wireless cable operators have access to the channels allocated to ITFS on a leased, part-time basis. Public Service Division, Federal Communications Comm'n, Communications Glossary 10 (1993). InterLATA - Telecommunications services that originate and terminate in different Local Access and Transport Areas ("LATAs"). Local Access and Transport Area - Contiguous local exchange areas developed in connection with the divestiture of AT&T within which Bell Operating Companies ("BOCs") may provide service. Pursuant to the Modification of Final Judgment ("MFJ"), BOCs are not permitted to transport calls across LATA boundaries but rather must connect them to interexchange carriers. Local Exchange Carrier ("LEC") - Carrier which transports calls within a local exchange area and provides customers access to long distance telecommunications services. The term is sometimes used to refer to the Bell Operating Companies and other local telephone companies. Modified Final Judgment ("MFJ") - Agreement between AT&T and the Department of Justice which, as amended by the federal courts, effected divestiture and imposed various restrictions on the Regional Bell Operating Companies (RBOCs). United States v. AT&T, 552 F. Supp. 131 (D.D.C. 1982), aff'd sub nom. Maryland v. United States, 460 U.S. 1001 (1983). See also Leland L. Johnson, Toward Competition In Cable Television 192 (1994). Motion Picture Experts Group ("MPEG") - A group within the International Standards Organization that developed the digital compression standard for voice and video. Multiplex - To transmit multiple signals over a single channel. National Television System Committee ("NTSC") - A committee comprised of industry representatives that established the NTSC standard for black-and-white television in 1940, and color television in the early 1950s. Optical Digital Loop Carrier System - System of routing calls through fiber optic cable originating from the central office of the LEC to remote distribution units. From these units, a conventional copper loop is used to connect subscriber premises. Trunk - A single transmission channel between two points that are usually switching centers. APPENDIX C TABLE 1: Cable Television Industry Growth, 1987-93 * U.S. Television Households from A.C. Nielsen Co. as of January of the year following that listed. Warren Publishing, Inc., 1988 Cable Television Factbook C-314, Warren Publishing, Inc., 1991 Cable Television Factbook C-344, Warren Publishing, Inc., 1994 Cable Television Factbook F-1. Source: History of Cable & Pay TV Subscribers & Revenues, Cable TV Investor, March 31, 1994, at 9. TABLE 2: Channel Capacity of Cable Systems, 1987-93 * Figures are as of April 1, 1987, April 1, 1990 and November 1, 1993. ** Percentage does not include systems for which information was not available Sources: Warren Publishing, Inc., 1987 Television and Cable Factbook A-41; Warren Publishing, Inc., 1990 Television and Cable Factbook C-385; Warren Publishing, Inc., 1994 Television and Cable Factbook F-3. TABLE 3: Channel Capacity for Subscribers, 1987-1993 * Figures are as of April 1, 1987, April 1, 1990 and November 1, 1993. ** Subs. = subscribers; percentages calculated based on totals that excluded subscribers for whom information was not available. Sources: Warren Publishing, Inc., 1987 Television and Cable Factbook A-41; Warren Publishing, Inc., 1990 Television and Cable Factbook C-385; Warren Publishing, Inc., 1994 Television and Cable Factbook F-3. TABLE 4: Growth By Network Type * A decline in the number of networks of a given type does not necessarily imply that those networks exited the market. It is equally as likely that several of the networks changed the nature of their services (and became "combination" networks, for example). Source: National Cable Video Networks by Type of Service, Cable Television Developments (National Cable Television Association), Apr. 1994, at 7-A. TABLE 5: Source of Revenue Source: History of Cable & Pay TV Subscribers & Revenues, Cable TV Investor, March 31, 1994, at 9; 1993 revenue from advertising (and accordingly, total revenue) adjusted based on Kathy Healy, Marketers Tune in to Cable's Appeal; Improvements Lead to Big Gains in Ad Spending, Advertising Age, Feb. 28, 1994, at C-3. TABLE 6: Cable Industry Expenditure On Programming, 1987-1993 Sources: * Paul Kagan Associates, Inc., Marketing New Media, March 15, 1993, p. 1; Paul Kagan Associates, Inc., Marketing New Media, June 20, 1994, p. 1; ** Cable Systems' Programming Expenditures, Cable Television Developments 7-A (National Cable Television Association Apr. 1994). TABLE 7: Cash Flow Figures of Cable System Operators * Displayed in descending order according to 1993 total basic subscribers, with the company's rank relative to all systems following in parenthesis. ** Includes both American Tel. & Communications Corp. (Time, Inc.) and Warner Cable Communications for 1987 and 1990, before the two were completely merged. *** Includes only Falcon Cable Systems, a division of Falcon Cable TV. **** The 1990 figures for E.W. Scripps are not included in the measure of change between 1987 and 1990. ***** Total estimate for industry cash flow was calculated by muliplying the estimated industry total revenue by cash flow margin for the group of companies. Sources: 1993 Annual Reports for listed companies; Paul Kagan Associates, Inc., The Cable TV Financial Databook 14-15, 37, 62 (1994); Paul Kagan Associates, Inc., The Cable TV Financial Databook 17-18, 41, 66 (1991); Paul Kagan Associates, Inc., The Kagan Cable TV Financial Databook 20-21, 28-59, 86 (1991); History of Cable & Pay TV Subscribers & Revenues, Cable TV Investor, March 31, 1994, at 9; Tom Kerver, Cablevision's Top 200, Cablevision, May 23, 1994, at 101-123. TABLE 8: Cable MSOs' Revenues and Subscriber Totals * Total at end of year. A calculation of revenue or cash flow per subscriber will be somewhat lower when the year-end total number of subscribers is used than when the average numbers of subscribers for the year is used. ** Displayed in descending order according to 1993 total basic subscribers, with the company's rank relative to all systems following in parenthesis. *** Includes both American Tel. & Communications Corp. (Time, Inc.) and Warner Cable Communications for 1987 and 1990, before the two were completely merged. **** Includes only Falcon Cable Systems, a division of Falcon Cable TV. Sources: 1993 Annual Reports for listed companies; Paul Kagan Associates, Inc., The Cable TV Financial Databook 14-15, 37, 62 (1994); Paul Kagan Associates, Inc., The Cable TV Financial Databook 17-18, 41, 66 (1991); Paul Kagan Associates, Inc., The Kagan Cable TV Financial Databook 20-21, 28-59, 86 (1991); History of Cable & Pay TV Subscribers & Revenues, Cable TV Investor, March 31, 1994, at 9; Tom Kerver, Cablevision's Top 200, Cablevision, May 23, 1994, at 101-123. TABLE 9: Cable Systems Sales Prices Source: The Year that Disappeared, Cable TV Investor, February 24, 1994, at 12; Mergermania: SW Bell, Cox Tie the Knot, Cable TV Investor, December 20, 1993, at 6. The Commission excluded transactions that had been reported in 1993, but were not consumated. TABLE 10: Cable System Transactions in Principle That Have Been Announced in 1994 * The transaction between Time Warner and Newhouse, which was also announced in September, is not included on this list because it involves the creation of a joint venture, and therefore, the Commission was unable to obtain an accurate valuation of the transaction. ** The totals and weighted average sales prices include both transactions involving the Maclean Hunter systems, but only include the differences between the systems involved in the transactions between TCI and Multimedia. Note: Table 10 includes all transactions that have been identified by the Commission at this time. It is not, however, purported to be a complete list of all transactions that have been announced in 1994. Sources: 1993 Cable Sales Stats: Telco Buys Bring Them Back to the Future, Cable TV Investor, Jan. 28, 1994, at 11; System Sales: Caught in Credit Crunch III, Cable TV Investor, Feb. 28, 1994, at 12; The Year that Disappeared, Cable TV Investor, Feb. 28, 1994, at 12; Systems for Sale, But Where Are the Buyers?, Cable TV Investor, Mar. 31, 1994, at 12; Deal Tally -- Few & Far Between, Cable TV Investor, Apr. 30, 1994, at 8; Adelphia Taps Into Tele-Media, Cable TV Investor, Jun. 7, 1994, at 3; System Sales Spring to Life, Cable TV Investor, Jul. 25, 1994, at 8; MSOs on the Way Out, Cable TV Investor, Aug. 31, 1994, at 6; Mark Robichaux, Adelphia to Buy 75% Control of Tele- Media, Wall St. J., Jun. 8, 1994, at A5; In Brief, Broadcasting & Cable, Jul. 4, 1994, at 56; Joe Estrella & John M. Higgins, TCI Swallows TeleCable Corp. in $1.5M [sic.] Deal, Multichannel News, Aug. 15, 1994, at 42; John M. Higgins, Newhouse Deal Sets Stage for New Sales, Multichannel News, Sep. 19, 1994, at 1; A Deal is Completed, N.Y. Times, Aug.9, 1994, at D-17. APPENDIX D Date Filed Telephone Company Location Homes Type of Proposal 10/21/92 Bell Atlantic-VA Arlington, VA 2,000 technical/ market 10/30/92 NYNEX New York, NY 2,500 technical 11/16/92 New Jersey Bell Florham Park, NJ 11,700 permanent 12/15/92 New Jersey Bell Dover Township, NJ 38,000 permanent 04/27/93 Southern New England Telephone West Hartford, CT 1,600 technical/ market 06/18/93 Rochester Telephone Rochester, NY 350 technical/ market 06/22/93 US West Omaha, NE 2,500 or 60,000 technical/ market 12/15/93 Southern New England Telephone (amendment) Hartford & Stamford, CN 150,000 technical/ market expansion 12/16/93 Bell Atlantic MD & VA 300,000 permanent 12/20/93 Pacific Bell Orange Co., CA 210,000 permanent 12/20/93 Pacific Bell So. San Francisco Bay, CA 490,000 permanent 12/20/93 Pacific Bell Los Angeles, CA 360,000 permanent 12/20/93 Pacific Bell San Diego, CA 250,000 permanent 01/10/94 US West Denver, CO 330,000 permanent 01/24/94 US West Portland, OR 132,000 permanent 01/24/94 US West Minneapolis/ St. Paul, MN 292,000 permanent 01/31/94 Ameritech Detroit, MI 232,000 permanent 01/31/94 Ameritech Columbus & Cleveland, OH 262,000 permanent 01/31/94 Ameritech Indianapolis, IN 115,000 permanent 01/31/94 Ameritech Chicago, IL 501,000 permanent 01/31/94 Ameritech Milwaukee, WI 146,000 permanent Date Filed Telephone Company Location Homes Type of Proposal 03/16/94 US West Boise, ID 90,000 permanent 03/16/94 US West Salt Lake City, UT 160,000 permanent 04/13/94 Puerto Rico Tel. Co. Puerto Rico 250 technical 05/23/94 GTE - Contel of Va. Manassas, VA 90,000 permanent 05/23/94 GTE Florida Inc. Pinella and Pasco Co., FL 476,000 permanent 05/23/94 GTE California Inc. Ventura Co., CA 122,000 permanent 05/23/94 GTE Hawaiian Tel. Co. Honolulu, HA 296,000 permanent 06/16/94 Bell Atlantic (amendment) Wash. DC LATA 1,200,000 permanent 06/16/94 Bell Atlantic Baltimore, MD; Northern NJ; DE; Philadelphia, PA; Pittsburgh, PA; and Southeastern VA 2,000,000 permanent 06/27/94 BellSouth Chamblee & DeKalb Counties, GA 12,000 technical/ market 07/08/94 NYNEX RI 63,000 permanent 07/08/94 NYNEX MA 334,000 permanent 09/09/94 Carolina Tel. & Tel. Co. Wake Forest, NC 1,000 technical/ market APPENDIX E MARKET AND TECHNICAL TRIALS, GRANTS AND PENDING APPLICATIONS FOR VIDEO DIALTONE 1. Since the adoption in 1992 of the video dialtone regulatory framework, the Commission has granted five applications for technical and market trials of video dialtone services, and one application for a permanent commercial video dialtone platform. Five additional applications for expanded, new market or technical trials are pending before the Commission, as well as twenty-three applications for permanent commercial authorizations. In this appendix the Commission briefly reviews the status of the trials, grants and pending applications. A. Technical and Market Trials 2. Bell Atlantic -- Arlington Technical Trial. The first technical trial was granted on March 25, 1993, to Chesapeake and Potomac Telephone of Virginia (now, Bell Atlantic - Virginia) for a one-year technical trial with up to 400 (employee) subscribers in Arlington, Virginia, to test ADSL technology. See Chesapeake and Potomac Telephone Company of Virginia, 8 FCC Rcd 2313 (1993). Subsequent to the grant, requests to extend the technical trial into a market trial and to expand the market trial to 2000 subscribers were filed with the Commission. See Application of Bell Atl. Co. for Section 214 Auth. to Provide VDT Servs. in No. VA. ("Bell Atl. No. Va. VDT Application"), File No. WPC 6834 (filed Nov. 9, 1993). Special temporary authority ("STA") was granted to allow Bell Atlantic to continue the trial until its application to expand and extend the service is granted, or for six months, whichever occurs first. The STA is due to expire September 25, 1994. The technical feasibility of the service in various network environments is being assessed in the second phase of the trial. Therefore, information on those aspects was not available for review prior to submission of this Report. Program supplier-customers on the Bell Atlantic trial platform in northern Virginia include: HBO, Medstar Communications, Inc., 20th Century Fox, Atrium Group, Inc., Metro-Goldwyn-Mayer Inc., Black Entertainment Television, MTM Entertainment, Inc., Miramar Productions, USA Networks, National Geographic Society Television Division, Multimedia Entertainment, Inc., Worldvision Enterprises, American Medical Television, and Walt Disney Pictures & TV. In its report on the status of its trial, Bell Atlantic reported that no access problems were reported by program supplier-customers. Six Month Compliance Report of Bell Atl. Co., Bell Atl. No. Va. VDT Application, File No. WPC-6834 (filed Sep. 23, 1993). 3. NYNEX -- Manhattan Technical Trial. The second technical trial was granted to New York Telephone (NYNEX) on June 29, 1993, for a one-year trial to test an HFC network, video switching technologies and methods for storing and delivering video programming in three multiple-dwelling unit ("MDU") buildings serving 2,500 subscribers in New York City. NYNEX proposed to employ switched and non-switched analog technology initially, and to incorporate digital technology such as asynchronous transfer mode (ATM) switch, compact disk-read only memory (CD-ROM) and digital storage as they became available. The network configuration involves fiber to a demarcation point within the MDU and coaxial cable drops to connect end-users within the MDU, with initial capacity estimates at 160 channels (the analog switch has 90 output ports and 160 input ports; access to switched video services initially is limited to 50 end-users). Application of New York Telephone Co. for Section 214 Auth. to Provide VDT Servs. in New York City ("NYNEX New York VDT Application"), 8 FCC Rcd 4325 (1993). NYNEX submitted the required report to the FCC on the status of the trial on July 15, 1994. Six Month Compliance Report of NYNEX, NYNEX New York VDT Application, File No. WPC 6836 (filed July 15, 1994). NYNEX reports spirited competition between its customer-programmers, particularly between Liberty Cable and Time Warner Cable. NYNEX is providing end-users a choice between two cable or direct-access programmer customers, Liberty Cable and Time Warner Cable, with a select number of end- users having access to on-demand programming from several information providers, including Liberty Cable, Time Warner, and Urban Communications Transport Corp. The programmer- customers participating in the stored access aspect of the trial include Capital Cities/ABC Video Entertainment, Educational Broadcasting Station WNET, Lincoln Center, Reuters, Archive Holdings, Advanced Research and Technology, Liberty Cable and Television, and Urban Transport. The NYNEX trial is being conducted in two phases. The first phase utilizes an analog system. The second phase of the trial, originally scheduled to begin in the fourth quarter of 1994, proposes to test a digital interactive system, while continuing to provide basic analog transport services. NYNEX reports a postponement in deployment of the digital phase of the trial due to delays in the availability of equipment. Id. 4. SNET -- West Hartford Technical and Market Trial. Southern New England Telephone Company (SNET) was granted a one-year authorization on November 12, 1993, for a technical and market trial to serve between 200 and 1600 customers in West Hartford, Connecticut and to test FTTN architecture with coaxial facilities from the node to individual subscribers. Application of Southern New England Telephone Co. for Section 214 Auth. to Provide CDT Servs. in West Hartford, Conn. ("SNET West Hartford VDT Application"), 9 FCC Rcd 1019 (1993). The system proposes to provide 110 channels of video initially, with possible expansion to approximately 500 channels using digital compression. In addition to delivering multichannel and single channel video, the network is intended to be capable of delivering to subscribers on-demand movies and other advanced interactive services, such as home shopping, educational and health care services. SNET is authorized to test enhanced and non-common carrier services such as digitizing, compressing, sorting video programming, operating a video switch and the provision of video customer premises equipment, in addition to testing customer interest in menu access and video-on-demand services. SNET also proposes to charge subscribers for the service to test interest and willingness to pay for services available from the video dialtone platform. Id. Shortly after grant of the technical and market trial, SNET requested an authorization to expand the trial to pass 150,000 homes. Request for Expansion of Serv., SNET West Hartford VDT Application, File No. WPC 6858 (filed Dec. 15, 1993). 5. U.S. West -- Omaha Technical and Market Trial. On December 22, 1993, U.S. West was granted an authorization for technical and market trials in Omaha, Nebraska. The technical trial will be for six months and may pass either 2,500 or 10,000 homes, depending on whether or not U.S. West files a tariff for the service. The market trial will be for the twelve months following the technical trial and may pass up to 60,000 homes. U.S. West will construct an advanced fiber-to-the-curb/coaxial cable network capable of providing 77 channels of analog video and between 800 and 1000 channels of digital capacity. See Application of US West Communications, Inc. for Section 214 Auth. to Provide VDT Servs. in Omaha, Neb., 9 FCC Rcd 184 (1993). U.S. West predicted that approximately fifteen percent of the homes passed would elect to participate in the trial. The grant was also conditioned on US West charging tariffed rates if the service passed more than 2500 homes. The architecture consists of a hybrid fiber-to-the-curb/coaxial cable network for video dialtone, voice and data service, with the components including a gateway that combines and distributes signals from video providers, fiber optic cables, video nodes that convert optical signals to electrical signals, coaxial cable distribution system and interdiction devices that provide network control and end user access to individual analog channels. Id. 6. Rochester Telephone Co. -- Rochester Technical Trial. The fifth authorized trial was granted on March 25, 1994 to Rochester Telephone Co., for six months to conduct a tariffed field test to serve up to 120 subscribers using two architectures: a fiber-coax system within multi-unit and single-unit dwellings, and an ADSL system utilizing Discrete Multi-Tone technology within a defined two mile area. See Application of Rochester Tel. Corp. for Section 214 Auth. to Provide VDT Servs. in Rochester N.Y., 9 FCC Rcd 2285 (1994). Rochester Telephone filed a tariff prior to commencement of its trial because it intends to charge both programmer-customers (the video information providers) and subscribers (end-users) for its video dialtone service. Rochester Telephone Corporation, Tariff FCC No. 3, Transmittal No. 224, filed May 17, 1994. Rochester states that it will construct, operate, own and maintain the facilities necessary to transport the video dialtone service, and the programmer-customer will supply, operate, and own the setup box and be responsible for providing all content and programming and service to the subscriber. Rochester's tariff indicates that the HFC network will provide programmer-customers 6-MHz channels and an interactive (4-MHz downstream and 40-KHz upstream) channel per specific customer location. The ADSL system will provide programmer-customers 6-MHz channels and an interactive (6-Mbps downstream and 16-Kbps upstream) channel per specific customer location. Rochester Telephone is testing the capabilities of the ADSL system to transmit a compressed digital video signal over embedded cooper loop plant in order to offer video dialtone service to customers located in areas where fiber optic and coaxial cable facilities have not been deployed. Rochester Telephone Corporation, Tariff FCC No. 3, Transmittal No. 224, filed May 17, 1994. 7. Additional Applications for Initial Trial. Three additional applications for initial trials are pending before the Commission. Puerto Rico Telephone Company has requested a one-year technical trial authorization to serve 250 homes using FTTC and 18 schools and 12 business offices using ADSL network architecture. See Application of Puerto Rico Telephone Co., File No. WPC-6949 (filed April 13, 1994). The trial proposes initial deployment of 64 analog video channels over the FTTC system, with future enhancement through digital compression to 384 channels. 8. BellSouth proposes an eighteen-month trial to pass 12,000 homes in DeKalb County and Chamblee, Georgia for the purpose of testing an HFC network offering both traditional channel service with 60 analog channels and a digital video dialtone platform with approximately 300 channels utilizing both digital multi-cast and digital point-cast. SeeBellSouth Application, File No. WPC-6977 (filed June 27, 1994). Digital multi-cast entails distribution of a digital video signal to everyone who subscribes, while digital point-cast is switched digital distribution. 9. Carolina Telephone and Telegraph Company has requested authorization for a two-year technical and market trial to 1000 homes in Wake Forest, North Carolina. SeeApplication of Carolina Telephone and Telegraph Co., File No. WPC-6999 (filed Sep. 9, 1994) 10. Trial Cost Estimates. The cost estimates for the various trials are as follows: C&P of Virginia, 400 end-user subscribers at a cost of less than $5 million; NYNEX, 2500 potential end user-subscribers at a cost of less than $3 million; SNET, 1600 potential end user- subscribers at a cost of less than $3 million; US West, 2500 potential end user subscribers at a cost of less than $8.4 million. US West Communications, Inc., 9 FCC Rcd at 188 n. 59. The trial proposed by Bell Atlantic for 2000 households in Virginia is estimated to cost over $11 million. Id. The Puerto Rico trial is estimated to cost approximately $2.5 million. B. Applications for Permanent Commercial Service 11. Twenty-four applications for permanent commercial video dialtone services have been filed with the Commission, including applications by six of the seven RBOCs, as well as GTE. Pacific Bell has filed applications for permanent authority to serve 210,000 homes in Orange County, 490,000 homes in San Francisco, 360,000 homes in Los Angeles and 250,000 homes in San Diego, CA. See File Nos. WPC-6913 to WPC-6916, filed December 20, 1993. U.S. West has requested permanent authorizations to serve 330,000 homes in Denver, CO, 132,000 homes in Portland, OR, 292,000 homes in Minneapolis-St.Paul, MN, 90,000 homes in Boise, ID, and 160,000 homes in Salt Lake City, UT. See File No. WPC-6919 filed January 10, 1994, File Nos. WPC-6921and WPC-6922, filed January 24, 1994, and File Nos. WPC-6944 and WPC-6945, filed March 16, 1994. Ameritech has requested permanent authorizations to serve 232,000 homes in Detroit, MI, 262,000 homes in Columbus and Cleveland, OH, 115,000 homes in Indianapolis, IN, 501,000 homes in Chicago, IL, and 146,000 homes in Milwaukee, WI. See File Nos. WPC-6926 to WPC-6930 filed January 31, 1994. GTE has requested permanent authorizations to serve 90,000 homes in Virginia, 476,000 homes in Florida, 122,000 homes in California and 296,000 homes in Hawaii. SeeFile Nos. WPC-6955 to WPC-6958 filed May 23, 1994. Bell Atlantic has requested permanent authorizations to serve 1.2 million homes in the Washington DC metropolitan area and 2 million in the Baltimore-New Jersey-Philadelphia-Pittsburgh area. See File No. WPC- 6912 as amended June 16, 1994, and File No. WPC-6966 filed June 16, 1994. NYNEX has requested permanent authorizations to serve 63,000 homes in portions of Rhode Island and 334,000 homes in portions of Massachusetts. See File Nos. WPC-6982 and WPC-6983 filed July 8, 1994 and supplemented on July 29, 1994. 12. The first permanent commercial video dialtone authorization was recently granted to New Jersey Bell for Dover Township. New Jersey Bell Telephone Co., 9 FCC Rcd 3677 (1994), pets. for recon. and mots. for stay pending, File No. WRC-6840, and appeals pending, Apelphia Communications, Inc. v. FCC, No. 94-1616 (D.C. Cir., Sept. 7, 1994). Pursuant to that grant, New Jersey Bell is authorized to construct and operate a video dialtone system to provide video dialtone service to approximately 38,000 homes using a FTTC architecture, with coaxial cable and copper wire for the final link to the home and providing initial digital capacity of 64 channels, conditioned upon expanding capacity to 384 digital channels in January of 1995. Id., 9 FCC Rcd at 3678. New Jersey Bell predicts that 35% of the homes passed will become end-user subscribers. Id. APPENDIX F Description of Program Access Cases Resolved (as of September 19, 1994) 1. Petition of Time Warner Cable for Exclusivity, 9 FCC Rcd 3221 (1994). Time Warner Cable filed a petition for exclusivity requesting authority to enforce, for a period of fifteen years, an exclusive distribution agreement with Courtroom Television (Court TV), a cable programming network. Liberty Cable, a SMATV operator, opposed the petition. On June 1, 1994, the Commission denied Time Warner's request. The Commission ruled that: (1) denial of access to Court TV to competitors will adversely affect competition in the local distribution market, because of its impact on Liberty's ability to compete in Manhattan and New York City, and could similarly limit the development of competition in other local distribution markets and in the national market; (2) Time Warner failed to show that exclusivity is necessary to either (a) attract capital investments for production, promotion, distribution, or carriage of Court TV, which is an established cable network with a growing subscriber base, or (b) promote diversity in programming; and (3) Time Warner would not be able to demonstrate that fifteen years is necessary, in any event, to justify exclusivity. 2. Petition of New England Cable News for Exclusivity, 9 FCC Rcd 3231 (1994). New England Cable News, a new regional cable news network, requested a public interest determination that would allow it to enter into exclusive program distribution agreements with cable system affiliates. The petition was unopposed. On June 1, the Commission granted the petition on the following grounds: (1) the ability to offer exclusivity to cable affiliates is necessary to attract investment and secure distribution essential to the financial viability of NECN; (2) NECN's ability to offer exclusive distribution rights to cable affiliates will foster diversity in the programming market; and (3) the public interest benefits of reasonably tailored exclusivity offset any detrimental effect exclusivity has on competition in the New England market. The Commission limited the exclusivity that NECN may offer to exclusive distribution for eighteen months to cable affiliates in the six New England states identified. 3. Consumer Satellite Systems, Inc. v. Lifetime Television, 9 FCC Rcd 3212 (1994). Consumer Satellite Systems ("CSS") filed a complaint against Lifetime Television, alleging excessive and discriminatory pricing for Lifetime's programming service. Subsequently, CSS requested dismissal of its complaint, because Lifetime had restructured its ownership so that it was no longer a vertically-integrated vendor. The parties also settled issues relating to pricing practices during the time that Lifetime was still subject to the rules. On June 24, the Cable Services Bureau dismissed the complaint, as not falling under the Commission's rules. 4. Mid-Atlantic Cable Service Co. v. Home Team Sports and Columbia Cable of Virginia, 9 FCC Rcd 3991 (1994). In June, 1994, the parties settled this complaint, which involved allegations of exclusivity, unfair practices and discrimination, including predatory pricing and undue influence. Both Mid-Atlantic and Columbia Cable serve Prince William County. Mid-Atlantic alleged it could not buy the Home Team Sports channel, but that Columbia could, because of Columbia's TCI affiliation. Although there was no exclusive HTS/Columbia contract, Mid-Atlantic alleged de facto exclusivity growing from and related to the other alleged unfair and discriminatory practices. Pursuant to the settlement agreement, the Cable Services Bureau dismissed Mid-Atlantic's complaint with prejudice. 5. Liberty Cable Company, Inc. v. Courtroom Television Network, 9 FCC Rcd 4035 (1994). Liberty Cable Company, a SMATV operator in New York City, alleged that Court TV had violated the program access rules by refusing to provide its programming to Liberty, based on an exclusive agreement with Time Warner Cable. Prior to the filing of this complaint, Time Warner had filed a petition for exclusivity with respect to its contracts with Court TV and Prime Ticket Network. On March 25, 1994, the Bureau held Liberty Cable's complaint against Court TV in abeyance pending the outcome of Time Warner's petition for exclusivity. See Complaint of Liberty Cable Co., Inc. v. Courtroom Television Network, 9 FCC Rcd 2324 (1994). On June 1, 1994, the Commission denied Time Warner's exclusivity petition. Time Warner Cable, 9 FCC Rcd 3221 (1994). The Bureau determined that under the terms of the Commission's Order, Court TV could not refuse to distribute its programming to Liberty or any other MVPD, on the basis of its exclusive distribution agreement with Time Warner. Accordingly, the Bureau dismissed Liberty's complaint as moot, but without prejudice to refile if subsequent negotiations gave rise to a new program access complaint. 6. Petition for Exclusivity of Time Warner Cable, 9 FCC Rcd 4029 (1994). Time Warner Cable filed a petition for exclusivity requesting the authority to enforce an exclusive distribution agreement with Prime Ticket Network in ten communities in southern California. Vanguard Communications, Inc., a SMATV and MMDS operator, and the California Attorney General opposed the petition. Time Warner Cable withdrew its petition and stated that it will not enforce the exclusive provisions of the distribution agreement. Vanguard requested that the Commission condition withdrawal and dismissal of the petition on Time Warner's amendment of the distribution agreement with Prime Ticket. The Bureau determined that such conditions were unnecessary because without a public interest determination from the Commission such exclusive distribution agreements are unenforceable. On August 1, 1994, the Cable Services Bureau dismissed the petition. 7. Petition of Walt Disney Company for Waiver of Program Access Rules, 9 FCC Rcd 4007 (1994). Disney requested a waiver of the program access rules so its subsidiary, The Disney Channel, would not be considered a vertically integrated programming vendor by virtue of Disney's operation (through a subsidiary, Madeira Land Company) of a cable system serving almost exclusively the Disney World hotels. The hotels receive the channel from the Madeira system and then distribute it to guest rooms using internal wiring. Disney claimed that Madeira's few subscribers -- the hotels -- constituted less than 1/1000th of one percent of The Disney Channel's subscribers, and that Madeira's monthly license fee for the channel accounted for less than 1/40th of one percent of the channel's revenues. Disney argued that its interests as a cable operator were so de minimis that it lacked any incentive to refuse to sell programming to a competing distribution system or discriminate against competing systems by charging higher rates for the programming or imposing other discriminatory conditions. The Bureau granted a conditional waiver, based on the fact that Madeira, although technically a cable system, is not the kind of distribution system the program access rules were designed to reach, and because the Disney Channel is widely available. The Bureau conditioned the waiver on Disney's reappearance before the Commission to have the waiver continue in force if Madeira either begins residential distribution or adds other non-Disney hotels to its distribution system. 8. Electric Plant Board, City of Glasgow, KY v. Turner Network Cable Sales, Inc., DA 94-974, (CSR-4188-P, released September 6, 1994). Glasgow's municipal utility and electricity board, an overbuilder, alleged that its competitor, Telescripps Cable Company, was illegally enforcing an exclusive programming distribution contract with Turner to distribute TNT. Because this is an "area served by a cable operator," this type of contract is not prohibited per se, but Glasgow alleged that the parties cannot enforce it without first obtaining a favorable public interest determination from the Commission. Turner claimed the contract was grandfathered, as it was entered into before June 1, 1990. Glasgow claimed that a new contract was made when the contract was modified and extended in August, 1990. The Bureau dismissed Glasgow's complaint because it determined that the contract was grandfathered under the 1992 Cable Act. The Bureau noted in its dismissal that the exclusive contract was scheduled to expire October 31, 1994 and at that time Turner would be obligated to negotiate with Glasgow or to petition the Commission for a public interest determination. 9. Hutchens Communications Inc. v. TCI Southeast and TCI of Georgia, DA 94- 975 (CSR-4230-P, released September 6, 1994). Hutchens, the owner and operator of a video production company, created and produced The Welcome Channel (TWC), that was carried by TCI initially without a lease fee. In 1993, TCI took the position that TWC was a leased access channel under the Commission's new rules and that a monthly lease was now warranted. Hutchens and TCI could not agree on the amount of the fee and TCI terminated carriage. Hutchens claimed that the fee was not justified under the leased access rules and was an unfair practice under the program access rules. Hutchens also claimed that TCI engaged in other unfair practices, including calling Falcon Cable (another cable system in the area that carries TWC) to encourage it to terminate TWC. TCI contended the fee was justified under the leased access rules, and that Hutchens' program access theory was misplaced, as Hutchens is not an MVPD. TCI also disputed Hutchens' other claims of unfair practices and claimed that the complaint was not properly verified and was untimely under the leased access rules. The Bureau dissmissed the complaint on the grounds that the leased access claim was untimely filed and that Hutchens lacked standing to bring a program access complaint because it did not fall within the statutory definition of a multichannel video programming distributor. 10. CableAmerica v. Times Mirror, DA 94-985 (CSR-4024-P, released Sep. 9, 1994). CableAmerica, a 9,000 subscriber MVPD in Mesa, Arizona, competes directly with Dimension Cable Services, a subsidiary of Times Mirror Cable Television, Inc., with approximately 40-50,000 subscribers. According to CableAmerica, Times Mirror owns the Arizona Sports Programming Network, which carries professional and other live sporting events featuring teams based in Arizona or otherwise of interest to Arizona residents. CableAmerica filed a complaint in January 1993. In February 1993, the Cable Television Branch sent CableAmerica a letter stating that the complaint was premature and that it would not be accepted for filing at this time because the Commission had not yet adopted its program access rules. CableAmerica filed a petition for reconsideration of this decision, which remained pending. CableAmerica refiled its complaint on August 10, 1993 alleging that ASPN refused to sell its programming to CableAmerica's Mesa system. Pursuant to a negotiated settlement agreed to by the parties, the Bureau dismissed the complaint. 11. Private Network Cable Systems Company v. SportsChannel New York, File No. CSR-4233-P. Private Network Cable Systems Company ("PNC") is a multichannel video programming distributor operating satellite master antenna television systems in two multi-unit housing complexes in Queens, New York. SportsChannel is a vertically integrated programmer who offers its programming to Time Warner, a direct competitor of PNC. PNC alleged that SportsChannel was discriminating against PNC vis-a-vis Time Warner in the pricing of programming. PNC recently filed a request to withdraw its complaint, with prejudice, because the parties have reached an amicable settlement. An order dismissing the case will be released shortly. APPENDIX G TABLE 1 1994 HORIZONTAL CONCENTRATION IN THE CABLE TELEVISION INDUSTRY Rank Company Total Industry 1 TCI 24.75% 2 Time Warner 12.53 3 Continental Cablevision 5.08 4 Comcast 4.82 Top 4 47.18 5 Cablevision Systems 3.78 6 Cox Cable 3.12 7 Newhouse 2.41 8 Cablevision Industries 2.33 Top 8 58.81 9 Jones Spacelink 2.24 10 Times Mirror 2.23 Top 10 63.29 Top 25 83.41 Top 50 92.42 HHI 898.00 TABLE 1A HORIZONTAL CONCENTRATION AFTER 1994 MERGERS IN THE CABLE TELEVISION INDUSTRY Share of Rank Company Total Industry 1 TCI 26.01% 2 Time Warner 15.21 3 Comcast 5.57 4 Cox Cable 5.35 Top 4 52.14 5 Continental Cablevision 5.08 6 Cablevision Systems 3.78 7 Cablevision Industries 2.33 8 Jones Spacelink 2.24 Top 8 65.57 9 Adelphia 2.17 10 Viacom 1.90 Top 10 69.64 Top 25 87.35 Top 50 95.16 HHI 1051.00 This table takes account of the effects of the following proposed transactions: (1) TCI's acquisition of Telecable; (2) Comcast's acquisition of Maclean Hunter systems in the United States; (3) Cox's acquisition of Times Mirror; and (4) Time Warner's joint venture with Newhouse. TABLE 2 CHANGES IN CONCENTRATION OF CONTROL OF THE CABLE INDUSTRY BASED ON TOTAL SUBSCRIBERS POST 1994 1989 1990 1991 1992 1993 1994MERGERS Top Co. Share 24.4 24.0 24.5 25.2 24.3 24.8 26.0 Top 4 Share 45.8 46.9 46.0 48.1 47.2 47.2 52.1 Top 8 Share 57.3 58.7 57.2 60.0 58.7 58.8 65.6 Top 10 Share 61.7 62.9 61.4 64.4 63.2 63.3 69.6 Top 25 Share 80.7 82.1 80.2 84.3 83.1 83.4 87.4 Top 50 Share 91.6 93.5 90.9 95.0 93.1 94.4 95.2 HHI 867.00 866.00 872.00 928.00 880.00 898.00 1051.00 Sources: Data for 1994 and Post-Merger taken from Appendix G, Table I & Table IA. Data for 1989 through 1994 was calculated from information appearing in Paul Kagan Assocs., Inc., Cable TV Financial Databook 16 (1990); Paul Kagan Assocs., Inc., Cable TV Financial Databook 14 (1991); Paul Kagan Assocs., Inc., Cable TV Financial Databook 12 (1992); Paul Kagan Assocs., Inc., Cable TV Investor 12 (1993); Paul Kagan Assocs., Inc., Cable TV Financial Databook 12 (1994). Data for 1994 was calculated from information appearing in Cable TV Investor, June 7, 1994, at 17. Total subscriber information was calculated from Cable TV Investor, March 31, 1994 at 9. The figure for total industry subscribers for 1994 is estimated by begining with year-end 1993 total and assuming continuation of the industry trend for total subscribers 1990-93. Data for 1991-94 have been recalculated after discussions with Paul Kagan Associates personnel about consolidated, non-consolidated and international subscribers. International subscribers for TCI are deducted from its total subscribers for 1991- 93; estimates for 1994 assume continuation of historical trends. TCI data for 1990 was calculated from its last year-end filing with the Securities and Exchange Commission. Tele-Communications, Inc., Form 10K I-2, I-4 (Dec. 31, 1993). APPENDIX H ECONOMIC CONCEPTS FOR ASSESSING THE EXTENT OF COMPETITION IN VIDEO PROGRAMMING DISTRIBUTION MARKETS Table of Contents Paragraph I. Demand-Side Concepts. . . . . . . . . . . . . . . . . . . .2 A. Own-Price Elasticity of Demand and Market Power .2 B. The Implicit Lerner Index . . . . . . . . . . . 4 C. The q Ratio . . . . . . . . . . . . . . . . . . .8 D. Empirical Studies on the Own-Price Elasticity of Demand for Basic Service. . . . . . . . . . . . 15 E. Empirical Estimates of the Implicit Lerner Index 18 II. Supply-Side Concepts. . . . . . . . . . . . . . . . . . . 20 A. Economies of Scale and Scope. . . . . . . . . . 20 B. Empirical Studies on Economies of Scale in Cable Television Distribution. . . . . . . . 24 C. Conditions of Entry . . . . . . . . . . . . . . 29 1. Fixed and Sunk Costs as Barriers to Entry. 32 2. Product Differentiation as a Barrier to Entry 39 3. Other Sources of Entry Barriers. . . . . . 42 4. Conclusion . . . . . . . . . . . . . . . . 44 D. Sunk Costs and Industry Structure . . . . . . 45 III. Methodological Issues . . . . . . . . . . . . . . . . . . 52 1. This Appendix describes certain economic concepts applied in this Report but not fully explained in the text of the Report itself. Additionally, certain additional economic information and analysis are provided that supplement the discussion in Section V that addresses the status of competition in multichannel video distribution markets. More specifically, Section I of this Appendix reviews the demand-side concepts of own-price elasticity of demand, market power, the implicit Lerner Index, and the q ratio. Section II reviews the supply-side concepts of economies of scale and scope and barriers to entry. The distinction between fixed and sunk costs is emphasized together with a brief analysis of the possible effects of sunk costs on long term market structure for local multichannel video programming distribution markets. Finally, Section III briefly addresses certain methodological issues raised in the Notice of Inquiry in this proceeding. I. DEMAND-SIDE CONCEPTS: MARKET POWER, OWN-PRICE ELASTICITY OF DEMAND, AND THE LERNER INDEX A. Own-Price Elasticity of Demand and Market Power 2. The nature of demand for any product or service is an important basic condition affecting market structure. In particular, the degree of consumer price sensitivity or to own- price elasticity of demand, is an indicator of the availability of competing substitute products or services. If consumer demand at observed market prices tends to be relatively insensitive to the level of market price, then it is likely that the product or service faces extremely limited competition from actual or potential substitute goods. If the supplier of such a product or service is a monopolist, then it is possible that observed market price will exceed the price that would otherwise prevail if either more competitors were supplying the market or other products or services were highly substitutable for the given product or service. In other words, measures of end-user price sensitivity are important in assessing the market power of suppliers. 3. Market power refers to the ability of a firm, or group of firms, to set price profitably above the competitive level and maintain such a price over time without attracting competitive entry. In a perfectly competitive market, equilibrium price is equal to marginal cost. Thus, if output price persistently remains above marginal cost over time, the firm does not face perfect competition and has, at least, some market power. The existence of market power is distinguished, however, from the extent of market power, since small deviations from marginal cost pricing will not, in general, imply serious distortions in market performance. B. The Implicit Lerner Index 4. To assess the extant market power of local cable systems, this Report applies two commonly used measures of market power, namely, (1) the Lerner Index; and (2) the q Ratio. The Lerner Index establishes a direct relationship between market power and the own- price elasticity of demand and is defined as L = [(p - MC)/p], where p and MC measure the unit output price and the marginal cost of production, respectively. The q ratio is the ratio of the market value of cable system assets to the replacement value of such assets and is described in Section I.C of this Appendix. 5. In most cases, it is difficult to compute reliable estimates of marginal cost at the equilibrium level of output. Consequently, direct estimates of the Lerner Index of market power are often impossible to compute. As an alternative methodology, the first-order condition for monopoly profit maximization can be used to compute an implicit estimate of the Lerner Index. The divergence of price from marginal cost can be formalized as the Implicit Lerner Index of market power which is given by the formula L = [(p - MC)/p] = (1/ ), where measures the own-price elasticity of demand. Given reliable estimates of the own- price elasticity of demand, , the extent of market power can be inferred indirectly without the requirement of estimating marginal cost at the profit-maximizing level of production. 6. The Lerner Index is a measure of the extent of market power. If the elasticity of demand for a firm's product is infinite, as it is in a perfectly competitive market, then the deviation of price from marginal cost is zero. As illustrated by the Lerner Index, the larger in absolute value is the own-price elasticity of demand, the smaller the divergence between monopoly and competitive price, where competitive price is just equal to marginal cost in the absence of economies of scale. As the number of substitutes for cable service increases, the elasticity of demand for video programming services offered by incumbent cable systems will increase. Thus, even if competition in local cable markets is between a few firms selling somewhat differentiated products, such rivalry may significantly increase the elasticity of demand for each of the rivals' services and eliminate significant deviations of price from marginal cost. 7. If the own-price demand elasticity of a dominant firm facing some competition is not known, the market share of the dominant firm, i.e., the percentage of total industry output supplied by the firm, can sometimes be used to compute the extent of market power. Given certain assumptions, the market power of a dominant firm, such as a local cable system beginning to face some competition, can be estimated using an estimate of the firm's market share; the own-price elasticity of the market demand curve; and the supply elasticity of rival firms, i.e., the percentage increase in quantity supplied by rival firms given a one percent change in output price. In this case, the Lerner Index, or the price-cost margin, can be written more generally as L = SD/[ m+îs(1 - SD)], where SD is the market share of the dominant firm; m is the market own-price demand elasticity; and îs is the supply elasticity of the rival or fringe firms. From this equation, it is apparent that the larger the market share of the dominant firm, the greater its market power, other things remaining the same. The larger (in absolute value) the market demand elasticity, other things equal, the larger will be the dominant firm's own-price demand elasticity and the smaller the deviation of price from marginal cost. The larger the supply elasticity of the competitors, measured by the ability of existing firms to increase output as well as new firms to enter the market, the larger the own- price demand elasticity of the dominant firm and, therefore, the lower its market power. C. The q Ratio 8. An alternative measure of market power is the q ratio, which is the ratio of the market value of a firm (measured by the market value of its outstanding stock and debt) to the replacement cost of the firm's physical assets. If the market value of a firm is greater than its replacement cost, excess economic profits are being earned. The market value of a firm consists of three components, namely, the capitalized value of rents attributable to monopoly power; scarce factors of production; and the firm's existing capital stock. The magnitude of the capitalized value of these rents is reflected by the extent that the q ratio exceeds one. The size of these rents reflects earnings in excess of the amount necessary to compensate all factors of production at rates equal to their full opportunity cost. The q ratio is a measure of long-run profitability, which makes it useful for measuring monopoly power for public policy considerations. The q ratio is often a preferable measure of profitability compared to the price-cost margin, since the difficulties in measuring marginal cost are avoided. 9. While the q ratio is an alternative to the Lerner Index as a measure of market power, the two measures can be directly linked under certain conditions. It can be shown that q = 1+(1/ )(R/K)[1/( - g)], where R is the firm's revenue for a given period of time; K is the dollar value of the firm's capital stock; (1/ ) is the simple Lerner Index; is the long term discount rate; and g is the projected long term percentage growth rate of revenue. From this equation, it is apparent that the Lerner Index (1/ ) and the q ratio tend to be correlated: large q ratios will be associated with large Lerner Indices, other things remaining constant. Much like the simple, inverse-elasticity Lerner Index, the q ratio measure of profitability is highly sensitive to the own-price elasticity of demand. If the firm sells its output in perfectly competitive output markets, then the firm's own-price elasticity of demand approaches infinity, and its inverse, (1/| |) or the simple Lerner Index, necessarily approaches zero in value. As a result, the expression (1/| |)(R/K)[1/( - g)] must also approach zero, and the q ratio converges to one in value, where by definition, the firm possesses no market power. Thus, it is apparent that q values in excess of one imply the exercise of market power, absent measurement problems or substantial violations of other assumptions inherent in the definition of q. 10. As noted in the 1990 Report, q ratios in excess of one may be attributable to factors other than excess economic profits. Since the q ratio is a fraction, incorrect estimates in either the numerator or denominator can have significant effects on the q estimates. Thus, inaccurate measures of either the market value or replacement costs of a firm's tangible assets can produce imprecise and misleading measures of q. 11. In general, the market value of a firm, the numerator of the q ratio, can be accurately estimated by summing the value of securities, i.e., stocks and bonds, issued by the firm. This approach is referred to as the "public" market value. However, if stock market values are extremely volatile, then this approach will produce less reliable estimates of firm value. For example, if the data are limited to a specific year, or even month, the value of securities may produce misleading estimates of the q ratio, if stock prices are abnormally high at that given time. This particular problem is minimal if stock prices are not volatile or the data are drawn from different time periods. 12. It is far more difficult, however, to obtain an estimate of the replacement value of the firm, the denominator of the q ratio. One particular measurement problem is the exclusion of the value of intangible assets, such as goodwill, in the estimate of replacement cost. If advertising, or some other factor, generates a positive amount of goodwill, the q ratio will typically exceed one, since goodwill will increase the market value of the firm but not its replacement value. In addition, since the assets of the firm are "used," estimated replacement costs may be affected by the particular accounting method chosen to adjust the assets for depreciation. Again, inaccuracies in the measurement of replacement cost will result in a q ratio greater than one, even if excess economic profits are zero. 13. Moreover, a particular firm's q ratio may be greater than one as a result of superior management skills or exceptionally efficient productive methods. Neither of these factors will be reflected in the estimate of replacement cost, but both will most likely affect the market value of the firm. It seems unlikely, however, that superior management skills or efficient production techniques can explain a significant portion of a cable firm's profits, given the current lack of effective competitive constraints on cable operators. Therefore, these factors are unlikely to have a significant effect on estimates of q for many, if not most, cable systems today. 14. Notwithstanding the possible conceptual limitations of the q ratio as a measure of market power, the estimated q ratios reported in Table 5.2 in the text of this report are so far above the benchmark value of one that it appears difficult to contradict the hypothesis of substantial market power in local cable distribution markets. Details describing the estimation of the q ratios and the pertinent assumptions made in the various computations are provided in Appendix I. D. Empirical Studies on the Own-Price Elasticity of Demand for Basic Cable Services 15. The calculation of implicit Lerner Indices requires robust econometric estimates of the own-price elasticity of demand for cable services, especially basic cable service. Fortunately, a number of recent econometric studies of the demand for basic cable service report estimates of the own-price elasticity of demand. These econometric studies provide various estimates of the own-price elasticity of demand for both basic and pay cable services. The econometric estimates of own-price elasticities for some of the more recent empirical studies are reported in Table H-1. Most empirical studies relate the unit price of cable service to either (1) the number of subscribers or (2) the penetration rate defined as the number of households subscribing to either basic or pay cable service divided by the number of households passed by cable. The own-price elasticity estimates are broadly similar despite different econometric specifications, estimation methodologies, and data sets. 16. The Crandall study estimates two demand model specifications, namely, Specification 1 that constrains the estimated elasticity to be a constant for all values of cable price and number of subscribers; and Specification 2 that permits the estimated elasticity to vary for different values of cable price and number of subscribers. As shown in Table H-1, the estimated own-price elasticities were not dramatically affected by the different instrument sets. Crandall's results suggest that the own-price elasticity of demand for basic cable service tends to be elastic, ranging from approximately 1.6 to 3.4, depending upon the model specification and instrument set. The Rubinovitz and Beil, et al., studies also show that the demand for basic cable tends to be elastic, although somewhat less elastic than shown in the Crandall study. Mayo and Otsuka find demand to be close to unity across the markets in their sample. According to their estimates, demand elasticities tend to be higher in urban areas and larger television markets. The Chipty study estimates own-price elasticities of demand for both basic and pay cable service. Again, these empirical estimates tend to show that the demand for basic (and pay) cable services are elastic. Finally, the Ford study shows that in duopolistically-competitive cable markets, the demand curve faced by the cable system operator is more elastic than in markets where competition is absent, i.e., in monopoly markets. 17. Notwithstanding the differing econometric methodologies and data sets, the demand elasticities reported in Table H-1 generally suggest that the demand for cable television tends to be elastic. To the extent that existing cable rates exceed the incremental cost of production, rate reductions should be expected to increase the number of subscribers and levels of penetration, and increase revenues for local cable systems, while possibly reducing local cable system profits. To the extent that local cable rates are the result of monopoly power exercised by local cable systems, additional competition should result in rate reductions for basic cable service as the elasticity of demand for the cable operator increases, a result consistent with the results reported in Ford's study. TABLE H-1 ECONOMETRIC ESTIMATES OF OWN-PRICE ELASTICITY OF DEMAND FOR CABLE TELEVISION Demand Measure Study Number of Subscribers Penetration Rate Own-Price Elasticity Estimate (| |) Crandall (1990)* Instrument Set A Specification 1 Specification 2 Instrument Set B Specification 1 Specification 2 Instrument Set C Specification 1 Specification 2 X X X X X X 1.760 2.329 2.134 3.375 1.578 2.151 Rubinovitz (1993)** X 1.46 Chipty (1994)*** Basic Cable Minimum Value Maximum Value Mean Value Pay Cable Minimum Value Maximum Value Mean Value X X X X X X 1.054 2.387 1.877 1.050 3.748 2.029 Mayo and Otsuka (1991)**** Top 50 Markets Urban Suburban Second 50 Markets Urban Suburban Below Top 100 Markets Average X X X X X X 1.51 1.05 1.22 0.98 0.81 0.969 Beil, et al (1993)***** X 1.09 Ford (1994)****** Specification A Monopoly Duopoly Specification B Monopoly Duopoly X X X X 0.87 1.51 1.31 2.62 Source: References cited in footnote 16. E. Empirical Estimates of the Implicit Lerner Index 18. The econometric estimates of the own-price elasticity of demand reported in Table H-1 that are consistent with the theoretical conditions for profit-maximization range from 1.054 to 3.375. Table H-2 reports estimates of the Implied Lerner Indices using a representative sample of the own-price elasticities reported in Table H-1. Table H-2 also reports the Implied Markup Factors that are derived from an algebraic restatement of the Lerner Index. The Implied Markup Factor expresses the profit-maximizing price as some multiple of marginal cost. Firms selling their output in a perfectly competitive market would set price equal to marginal cost, implying a markup factor equal to one. Markup factors in excess of one are indicative of market power. Similarly, the value of the Lerner Index for a firm selling in perfectly competitive output markets is zero, since a competitive firm does not realize any markup over the marginal cost of production. TABLE H-2 IMPLICIT LERNER INDICES FOR CABLE SYSTEMS Econometric Study Basic Service Own-Price Elasticity of Demand [ ] Implied Lerner Index [1/ ] Implied Markup Factor [ /( - 1)] Rubinovitz (1993) 1.46 0.69 3.17 Chipty (1994) 1.88 0.53 2.14 Crandall (1990) Specification B1 Specification B2 2.13 3.38 0.47 0.30 1.88 1.42 Ford (1994) Monopoly Duopoly 1.31 2.62 0.76 0.38 4.22 1.61 Source: Table H-1. 19. If it is assumed that local cable systems attempt to set profit-maximizing prices for basic cable service, then the presence of market power is implied for the range of empirical estimates of the own-price elasticity of demand shown in the second column of Table H-2. The Implied Lerner Index suggests that the percentage markup over profit-maximizing price, i.e., [(p - MC)/p], ranges from thirty to seventy-six percent. Similarly, the Implied Markup Factors range from 1.42 to 3.50. With regard to overbuild competition, the Implied Markup Factors produced using Ford's own-price demand elasticity estimates clearly show that such competition diminishes market power. II. SUPPLY-SIDE CONCEPTS A. Economies of Scale and Scope 20. Changes in the cost of production as output expands may have an important effect on market structure. If, for example, the average cost of production is little affected by the quantity produced by any given firm in an industry, then the market might be supplied by many firms, with no individual firm having any important cost advantage relative to any other. In other words, the scale of production does not affect the cost of production for any firm in the industry. Under these circumstances, market structure may resemble a perfectly competitive industry, unless various types of barriers to entry preclude competitive entry. 21. Conversely, should the expansion of output by any given firm result in a reduction in the average cost of production as higher-capacity facilities are used to produce higher volumes of output, then market structure may be dominated by a few firms that supply the entire market. In such a case, each firm realizes economies of scale in the production of output, although such production economies are usually exhausted at sufficiently large volumes of production. In a special, limiting case, a single enterprise may be able to supply total market demand at least total cost compared to multiple competing suppliers, reflecting the application of a technology of production so technically efficient at large levels of output that only a single supplier is required. Such a firm is called a natural monopoly. Often, firms defined as natural monopolies are treated as public utilities and subjected to regulation. Historically, such regulation precludes competitive entry, since, by definition of a natural monopoly, any competitor to the public utility can only produce output at higher average cost and, hence, a higher price to the consumer relative to the prices charged by a regulated natural monopoly firm. 22. The cost structures of firms that supply multichannel video programming to subscribers are likely to be both complex and dynamic over the longer term as new technologies of video programming distribution become more widely available. Analytically, a multioutput cost function is a useful tool for understanding the behavior of plant-level costs of production. In particular, such a cost function permits the definition and measurement of product-specific economies of scale and economies of scope, the cost savings attributable to producing multiple outputs in the same plant using certain shared inputs of production. For a firm that produces a single output, large economies of scale in production may be sufficient to result in a natural monopoly. Most firms, however, produce multiple outputs. The notion of natural monopoly in the case of multiple outputs is necessarily more complicated than the single-output case, although recent theoretical work on the economics of multioutput production have established the cost conditions defining natural monopoly under these circumstances. 23. Technological change, learning curve effects, and systems rivalry between and among competing multichannel video programming distributors may accentuate economies of scale and scope in video programming delivery through time. Such economies do not, however, imply a natural monopoly market structure in local video programming distribution markets over the longer term, although such economies may constrain the number of profitable video programming delivery systems in some local markets. Such industry cost conditions are unlikely to represent policy-relevant barriers to entry, however, since their realization is likely to be the result of systems rivalry rather than an impediment to such competition. Some insight concerning the extent of possible economies of scale and scope is provided by econometric studies of cable system cost functions. Several of these studies are reviewed in the next section. B. Empirical Studies on Economies of Scale in Cable Television Distribution 24. Rigorous study of the cost structure of local cable systems requires the formulation and estimation of multioutput econometric cost functions. Two empirical studies estimate the cost structure of local cable systems, namely, studies by (1) Owen and Greenhalgh and (2) Noam. Both studies find some evidence of economies of scale, although such economies are not large. 25. Owen and Greenhalgh estimate a fourteen percent cost penalty to overbuilding using data from franchise applications, where output is defined as the number of subscribers. This estimate overstates the cost penalty of overbuilding, since total market output is assumed to be constant, i.e., no price competition results from overbuilding. Empirical studies on competition in the cable industry suggest, however, that total market output tends to increase as marginal customers subscribe to basic cable service in response to a reduction in price. When changes in the output of the cable system are measured not only as an increase or decrease in the number of subscribers, but include proportional changes in the amount of institutional (local public, educational, and government) network investment and miles of wire (cable plant), Owen and Greenhalgh's estimates show that the average cost of production is approximately constant with respect to a proportional change in all three measures of output. As noted by the authors and subsequent studies, Owen and Greenhalgh's estimates are troublesome, however, since the franchise application data used in their study are only estimated construction and operation expenditures. Such data include the estimates of both efficient and inefficient bidders; could be biased by opportunistic behavior or "gamesmanship;" and ". . . do not clearly reflect the minimum cost based on using best-practice techniques of running a cable system of a given size." 26. In a more sophisticated attempt at measuring scale and scope economies in cable distribution, Noam estimates a series of cost functions using 1981 data for more than 4800 cable systems. His estimates suggest the presence of economies of scale in the production of cable services, but the economies vary according to the definition of output. Product-specific scale elasticity estimates for the outputs defined as "basic subscribers," "pay subscribers," and "homes-passed" are 1.054, 1.074, 1.020, respectively. Product-specific economies of scale are observed for the basic and pay subscriber output measures. The product-specific scale elasticity estimate for the homes-passed measure of output is not statistically different from one, however. These results suggest that economies of scale are observed only in the number of basic and pay subscriptions, and not the physical size of the network, i.e., homes-passed. Taking into account economies-of-scope between the size of the distribution network and the number of subscribers for both basic and pay cable services, Noam's estimates indicate slight economies of scope; the total scale elasticity estimate is calculated to be 1.096, implying that a ten-percent decrease (increase) in all outputs in fixed proportion will result in approximately a one-percent increase (decrease) in the cost of production. The scale elasticity estimates from the Noam study (the most sophisticated to date) do not suggest, however, that significant economies of scale -- regardless of the measure of output -- pervade the cable distribution industry. 27. Based on the two econometric cost studies, competitive entry in local multichannel video programming markets may appear to imply some loss in economic benefit to consumers, since such entry may prevent the incumbent cable system from fully realizing all the economies of scale and scope inherent in the production of cable services. Such an inference, however, ignores the possible benefits of competitive entry. For example, if post- entry prices are lower than pre-entry prices, then cost penalties must be weighed against increases in consumer welfare resulting from lower prices. Therefore, even if economies of scale are present, gains in consumer welfare from lower prices may be expected to more than offset the cost penalty of duplicated facilities. As a result, allowing open-entry into local cable markets, where such entry results in lower prices, can increase net social welfare (exclusive of product variety), despite some loss in static economic efficiency resulting from foregone economies of scale. 28. Although local cable distribution networks are probably characterized by slight economies of scale, empirical evidence concerning the favorable price effects of overbuild competition suggest that entry restrictions in local cable markets are likely to be economically- inefficient and detrimental to the welfare of consumers. Given the prospective entry of competitors using different local distribution technologies, such as MMDS, DBS, and LECs, natural monopoly cost characteristics may tend to constrain the number of overbuilders in most local cable markets but need not necessarily constrain the extent of competitive rivalry that should tend to improve consumer welfare over the longer term. C. Conditions of Entry 29. Barriers to entry and exit are probably the single most important factor influencing market structure. For public policy purposes, however, the concept of barriers to entry should be carefully defined. Bain specified three sources of barriers to entry, namely, (1) the absolute cost advantages of incumbent firms; (2) economies of scale; and (3) the product differentiation advantages of incumbent firms. Stigler proposed a more general definition of barriers to enter, namely, ". . . a cost of producing (at some or every rate of output) which must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry." Stigler's general definition of a barrier to entry is broadly accepted in many contemporary industrial organization studies. Christian von Weizs„cker proposes a more restricted definition of a barrier to entry that qualifies Stigler's definition, namely, a barrier to entry is ". . . a cost of producing which must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry and which implies a distortion in the allocation of resources from the social point of view." Weizs„cker's definition of a barrier to entry suggests in effect that the proposed removal of a barrier to entry requires a cost-benefit analysis that identifies all gains in economic efficiency, including relevant externalities, that are derived from the presence of the entry barrier as well as the actual or potential losses in economic efficiency resulting from the entry barrier, including all costs implied in eliminating or minimizing its effects. 30. Since some models of market competition establish a direct relationship between the number of firms supplying the market and the quality of market performance, it appears self-evident that any obstacle impeding the free and easy flow of new firms into the market must have a direct and unequivocal adverse effect on market performance. As a result, the elimination of any impediment to entry should produce an unambiguous, although possibly small, incremental improvement in market performance and consumer welfare. Following this logic, the "optimal" public policy toward impediments to market entry is, therefore, one of "zero tolerance." 31. Closer examination of a zero tolerance policy toward barriers to entry suggests, however, that such a policy without important qualifications is unlikely to be optimal. From a public policy perspective, not all impediments, however, are necessarily barriers to entry that require some type of government intervention or remediation. For purposes of this Report, costs borne by entrants but not incumbents that have adverse affects on consumer welfare are defined as policy-relevant barriers to entry. Barriers to entry defined in this way are candidates for regulatory or antitrust scrutiny, where such scrutiny may result in policy recommendations for reducing or eliminating such entry barriers. Such scrutiny should be approached as a cost-benefit analysis that identifies all possible economic efficiencies, if any, that might result from the presence of the barrier to entry; identifies all offsetting economic inefficiencies that might be attributable to the barrier to entry, if any; identifies all relevant positive and negative externalities; and, finally, estimates the economic cost of eliminating the barrier to entry or minimizing its effects. 1. Fixed and Sunk Costs as Barriers to Entry 32. The existence of both scale and scope economies in local cable system networks may represent a limited impediment to unconstrained market entry by potential overbuilders. The essential question is whether such an impediment to entry is also a policy-relevant barrier to entry. Answering this question, however, requires a careful distinction between several types of cost, especially, fixed costs and sunk costs. 33. For a single-output firm, economies of scale are a consequence of enlarging the production capacity of a plant by installing higher-capacity facilities and enlarging, as necessary, the labor force necessary to produce at larger levels of output. At this higher level of output, the average total cost of production, i.e., the sum of total fixed cost plus total variable cost, divided by the higher level of output, is lower compared to the average total cost of production for smaller levels of output where the capacity of productive facilities is smaller. In general, total fixed cost ordinarily represents the estimated dollar value of the annual (implied) flow of productive services rendered by capital equipment, such as investment in cable headend and distribution facilities, that do not vary with small changes in the level of output. 34. Achieving a lower total average cost by investing in high-capacity production facilities requires a substantial capital investment and is sometimes described as a capital barrier to entry. So long as both the incumbent and the entrant can acquire the same large- scale production facilities at the same purchase price, large total fixed costs implied by investment in high-capacity production facilities do not meet the definition of a policy-relevant barrier to entry. Implicit in the conclusion, however, is a crucial assumption that the fixed cost of high-capacity facilities cannot be reduced by reducing the level of production, but can be eliminated by total cessation of production. In other words, fixed cost can be eliminated by shutting down production altogether and redeploying the capital assets to some other production process within the firm or selling the assets to some other firm. Indeed, the incumbent may be willing to sell the capital assets to an entrant at the current opportunity cost of the assets and abandon production in this particular market. 35. If, however, the high-capacity production assets cannot be redeployed to some other profitable use and should the continued production of output in the existing application become unprofitable, then the fixed cost represented by the investment in such capital assets becomes a sunk cost. By definition, sunk costs cannot be eliminated even by total cessation of production. Since sunk cost assets cannot be redeployed, they have no opportunity cost. As a simple example, investments in railway cars are largely a fixed cost, apart from ordinary wear and tear resulting from usage. If the current usage of a railway car between two points, A and B, becomes unprofitable, then the railroad can easily redeploy the cars to some other route. The fixed cost represented by the investment in roadbed between points A and B obviously cannot be redeployed and, therefore, represents a sunk cost. 36. The policy significance of the difference between fixed and sunk costs is important. While fixed costs do not ordinarily represent a policy-relevant barrier to entry, sunk costs sometimes do. Sunk costs may have a direct, and sometimes dramatic, effect on the behavior of dominant firms, such as local cable system operators. Much like the railroad track example above, the costs of constructing a cable distribution network may be viewed as sunk, where the coaxial cable plant is analogous to the roadbed investment by railroads. Significant aspects of the cable distribution and video programming industries are characterized by sunk costs. As a result, strategic behavior by incumbent cable systems may be anticipated as a factor directly affecting market structure for local distribution of video programming. 37. If entry into an industry requires large sunk costs, the value of incumbency can be substantial. Incumbent systems may be able to use their incumbency to forestall or deter competitive entry via a number of entry deterring strategies. In general, economic models of entry deterrence stress the inherent advantage in making the "sunk" investments first, thereby limiting the opportunities for profitable entry later. For example, suppose that an incumbent cable system has wired an entire franchise area. A potential entrant will realize that any large scale entry into that market will probably force price down, as the output of the entrant is absorbed by the market. Even if the costs of the entrant are as low as those of the incumbent, the post-entry price may fall below average cost, and entry will prove unprofitable. If the prospective entrant's expectations match this scenario, entry is deterred. This entry-deterrent effect depends on the expectations of the entrant about post-entry behavior of the incumbent, the degree of economies of scale, and the level and nature of demand. 38. If an incumbent sets price at the monopoly level, then a prospective entrant may perceive entry to be profitable. The incumbent may be able to deter entry, however, by setting a limit price, i.e., a price below monopoly price but above average cost. The incumbent, by accepting less than maximum profit in the short run, prevents entry and maximizes profit in the long run. The implications of a limit pricing strategy for consumer welfare are complex. Since a limit price is lower than the monopoly price, it clearly enhances consumer welfare. If the limit price is above the duopoly price, then potential welfare is diminished by the entry- deterring effect of the limit price. Thus, consumer welfare is directly affected by the type of limit pricing strategy that an incumbent cable system may adopt. 2. Product Differentiation as a Barrier to Entry 39. In addition to sunk costs, product differentiation is sometimes viewed as an impediment to entry in local markets for multichannel video programming distribution. Incumbent cable systems may have an advantage over potential entrants arising from consumer preferences for their products. This preference might be the result of advertising, goodwill, reputation, inertia, or other factors. Product differentiation, according to Bain, is a barrier to entry as entrants must entice customers with a lower price and/or incur a greater selling expense per unit than the incumbent(s). Greater selling expenses, incurred only by the entrant, make product differentiation a Stiglerian barrier to entry as well. 40. Product differentiation may constitute a barrier to entry if the extent of differentiation is sufficiently "intense," i.e., consumers perceive alternative products as poor substitutes for the differentiated product or service. Intense product differentiation tends to steepen the slope of the demand curve for the differentiated product and increase the margin of price over the marginal cost of production. As a result, advertising and other marketing expenditures that effectively deepen the consumer's perception that a product or service or certain of its attributes is unique relative to possible substitutes both preserves price-cost margins and may make it more difficult for an entrant to launch a competitive product or service. An entrant must incur promotional expenditures to overcome the incumbent's existing market dominance. Such expenditures are unrecoverable by the entrant in the event of market exit and may constitute, therefore, a sunk cost impediment to entry. 41. One view of competition in cable television holds that successful entrants must be able to sell an identical product, leaving price competition the only option; however, it is possible that competition in local cable markets may be enhanced by greater product differentiation. Avinash Dixit shows that entry is easier if two products, the incumbent's and the prospective entrant's, are more differentiated, i.e., poorer substitutes. For example, if two goods were not considered substitutes (e.g., peanut butter and cars), then incumbent firms would have no incentive to deter entry. Interestingly, entry is more easily prevented if the incumbent can claim that its product is a good substitute for the prospective entrant's product. If the substitutability of goods enhances impediments to entry, then incumbent cable firms may be able to slow entry by expanding channel capacity, using programming proliferation to make interfirm differentiation more difficult. Thus, incumbent cable firms may increase the quantity and quality of programming in order to lower the profitability of entry, even in niche markets. If entry does occur, product differentiation will allow a firm to exploit monopoly power more effectively by "claiming a special niche for [its] product" that more closely match the diverse preferences of consumers. Thus, if consumers prefer extensive variety in programming choices, entrants may find it more profitable, at least initially, to compete with the incumbent cable system by offering complementary rather than competitive programming. 3. Other Sources of Entry Barriers 42. Although not fully addressed in this Report, other impediments to market entry in local multichannel video programming distribution markets may grow in importance as competition develops. For example, the network nature of video distribution, whether over wire or air, implies the existence of network effects and the applicability of the systems competition literature. If compatibility between systems becomes an issue, then barriers to entry may arise. For example, if costly system-specific interfaces are developed, the fact that potential entrants must convince customers to switch interfaces, losing both the financial and human capital investment, may effectively impede entry. These network effects are more likely to be an issue for wireless entry as system-specific receivers must be purchased by the subscriber. 43. In the 1992 Cable Act, Congress addressed two particular policy-relevant entry barriers, namely, access to video programming and exclusive franchise contract rules. By foreclosing access to a vital input, such as cable programming, incumbent cable firms can erect a potential entry barrier that impedes or deters competitive entry. This foreclosure can occur either through the bargaining power of a large incumbent (an MSO for example), or by the downstream firm vertically integrating into the programming market and refusing to sell its programming to actual or potential rivals. Program access for multichannel video programming distributors using alternative technologies was addressed by the 1992 Cable Actand enforcement of the rules appears successful. The local franchise process is, perhaps, the most important policy-relevant barrier to competitive entry in local cable markets. Recognizing the potential barrier that franchising poses, Congress, in order to further competition in the cable industry, prohibited the "unreasonable" denial of a competitive franchise in the 1992 Cable Act. The effectiveness of this prohibition has yet to be determined. 4. Conclusion 44. This discussion suggests that the presence of various types of sunk costs in the cable television industry probably represents policy-relevant barriers to entry in local multichannel video programming markets. As a result, entry-deterring behavior by incumbent cable systems may be anticipated as competition between cable systems and other MVPD firms develops. This Report does not propose, however, a policy response to this possible anticompetitive conduct at this time. D. Sunk Costs and Industry Structure 45. The pervasiveness of sunk costs may have a decisive effect on long term industry structure. Explaining the relationship between sunk costs and industry structure depends on the distinction between exogenous and endogenous sunk costs. Exogenous sunk costs represent irreversible investments in productive capacity determined in substantial part by the current technology of production. Thus, in the cable industry, the investment in headend and local distribution facilities sufficient to serve a defined service area represents exogenous sunk costs: both the current technology of multichannel video distribution and the service requirements established by franchising authorities are exogenous factors that drive the amount of investment that a cable operator must commit to a particular multichannel video distribution market. More simply, business firms in general and cable operators in particular have very limited discretion in determining the magnitude of exogenous sunk costs. 46. By contrast, endogenous sunk costs represent expenditures on inputs of production that business firms in general and cable operators in particular can vary with substantial discretion in pursuing business objectives. In general, spending on advertising and research and development are prominent examples of endogenous sunk costs. Although the firm can vary the amount of spending on such inputs of production, such spending, once made is necessarily committed to a particular purpose or business objective and cannot be costlessly redirected to some other purpose. In the cable television industry, spending on video programming is a conspicuous example of a major endogenous sunk cost: spending committed to one type of programming cannot be costlessly redeployed to another type of programming. 47. The analytical significance of the distinction between exogenous and endogenous sunk costs in the cable industry is apparent if the evolution of industry structure is viewed as a two-stage game. In the first stage of the game, a cable operator invests in a local distribution network of sufficient scale to serve subscribers in the franchised service area. These fixed setup costs incurred in this first stage of the game represent exogenous sunk costs. 48. The second stage of the game analyzes the nature of price competition that occurs after the sunk setup costs are incurred. Prices for video programming services set at the second stage of the game depend only indirectly on the exogenous sunk costs required to enter the market, however. More specifically, setup costs influence the entry decision of potential competitors. If the exogenous sunk costs implied by market entry are not perceived as unreasonably large, then more firms will enter the market for local multichannel video programming, leading to greater price competition in the second stage of the game. 49. From this conceptual viewpoint, entry decisions of firms into local markets for multichannel video programming will be influenced by the interplay between the levels of setup costs in the first stage of the game and the intensity of price competition that firms face at the second stage. If price competition is intense at the second stage of the game, then post- entry profits will be lower, all other things remaining the same, and the fewer will be the number of firms choosing to enter the market for local video programming. Thus, long term market structure will reflect a tension between the level of exogenous sunk costs that must be committed to enter the market -- and that must be recovered to justify entry ex-post -- and the intensity of price competition that occurs in the second stage of the game. In general, more entrants will tend to increase the intensity of price competition. Lower prices resulting from such competition will make entry less attractive, however, to still other potential entrants. 50. Implicit in the foregoing analysis of exogenous sunk costs and price competition is the assumption that each entrant in the local market for multichannel video programming offers similar, or virtually homogenous, programming to its subscribers. If, however, different firms offer their subscribers substantially-differentiated programming compared to that offered by competitors, then long-term market structure may differ from that of the homogenous product case. Spending on programming is an endogenous sunk cost that a cable operator can vary to deepen the extent of product differentiation relative to the programming offered to subscribers by competitors. Other things remaining the same, increases in endogenous sunk costs may be expected to enhance the subscribers' willingness to pay for the video programming package offered by the cable operator and, thereby, weaken the extent of price competition in stage two of the game. Therefore, unlike the case of homogenous programming offered by competing cable operators, market structure may still remain relatively concentrated, notwithstanding the relatively higher level of post-entry profits that persist given the weakened level of price competition. 51. This discussion illustrates in a highly simplified way how both exogenous and endogenous sunk costs may have a decisive effect on the evolution of local market structure for multichannel video programming distribution over the longer term. This analysis identifies possible trade-offs between the number of actual competitors in any local cable market and the intensity of price competition that might prevail. Implicit in the analysis is the possible influence that large market areas served by any given cable operator may have in reducing market concentration; more firms may be willing to commit to the exogenous sunk costs required to enter the market if the universe of potential subscribers is larger. As a result, the possible entry-deterring effects of vigorous price competition in the stage two game would be mitigated to some extent. Such market structure implications should help guide both the nature of inquiry and policy analysis in future reports. III. METHODOLOGICAL ISSUES 52. The assessment of the extent of competition in the market for the delivery of multichannel video programming may be approached from alternative perspectives. In general, the few comments received on methodology recommended that a legal and economic approach should inform the Commission's analysis and urged the Commission to take a relatively broad view of competition in this and future reports. For example, WCA would like the Commission to seek data that will permit a competitive analysis broader than the "wired" market. TCI urges the Commission to adopt a dynamic approach to analyzing competition in the delivered video programming market. Similarly, Time Warner states that the Commission should take a broad approach in its methodology which would consider virtually all information and entertainment media in its analysis. Finally, Home Box Office ("HBO") submitted a paper by Professor Paul L. Joskow which examined various methodologies the Commission could and should adopt in studying "competition". HBO and Professor Joskow urge the Commission to use "comparative institutional analysis" as a means of assessing competition, which would broadly apply the tools of modern industrial organization economics to this industry. 53. As proposed in the Notice of Inquiry in this proceeding, a prominent methodological approach developed in the field of modern industrial organization economics is the structure-conduct-performance (SCP) paradigm. The SCP methodological framework facilitates the systematic study of the extent of competition from a variety of viewpoints, and is broad enough to accommodate a number of more specialized approaches toward the study of competition. In a general way, the organization of this Report is consistent with the SCP paradigm. The Commission, however, is not adopting a specific methodology for assessing the extent of competition in markets for multichannel video programming distribution at this time. Future reports, however, may address such methodological issues at greater length and propose a general methodology that is consistent with the purposes of such studies on competition in video programming distribution markets. APPENDIX I 1. This appendix describes the q ratio calculations that appear in Section V of the main text. The q ratio, defined as the ratio of the market value of a firm to its replacement cost, is a measure of market power. The Commission discussed its properties in the 1990 Cable Report. This appendix addresses the "nuts and bolts" details of the calculations. The broad procedures used follow those used by Professor Paul MacAvoy in a 1990 submission to the Commission. 2. MacAvoy used two separate techniques for calculating market value. He calculated "public" market values for a sample of "pure" cable companies (i.e., companies whose sole business activity was cable television delivery). The public market value is the sum of a firm's liabilities and the value of its outstanding stock (price multiplied by number of outstanding shares). This figure may then be divided by the number of subscribers that the firm serves. Table I-1 shows 1993 public market value calculations for the four firms that the Commission identified as pure cable companies. Two of them, Adelphia and TCA, were also in the MacAvoy sample. (The other three firms in the MacAvoy sample are American TV and Communications, Falcon Cable Systems Co., and Galaxy Cablevision.) 3. The second market value concept is "private" market value. This is the subscriber-weighted average of per subscriber selling prices of cable companies during a relevant period. Table I-3 contains two such estimates, one based on twenty-four 1993 transactions and one based on six announced 1994 transactions. In each case, only cash transactions are included in the calculation, because it is difficult to determine an equivalent cash value for transactions with other components. 4. MacAvoy also employed two techniques for calculating replacement costs. The first is based solely on financial data for pure cable companies and consists of an estimate of adjusted book value of tangible assets. For each pure cable company, tangible assets are divided into net plant and other tangible assets. Net plant (i.e., depreciated book value of plant) is adjusted for inflation and added to other tangible assets, and the sum is divided by the relevant number of subscribers. The inflation adjustment is based on a rough estimate of the average age of plant. The average age of plant is taken to be the difference between gross and net plant divided by current annual depreciation. That average age is multiplied by an annual inflation rate (assumed herein to be four percent) to get the percentage by which net plant must be increased to adjust it for inflation. 5. The second replacement cost method uses current construction cost estimates to derive a net plant figure. This procedure entails adjusting current construction cost per subscriber for depreciation to obtain net plant per subscriber. Adding this net plant figure to other tangible assets per subscriber (from the sample of four pure cable companies) yields an estimate of replacement cost per subscriber. The average ratio of net to gross plant for all cable companies in the data source (the Paul Kagan Cable Financial Databook) is used to adjust current construction costs. Table I-2 exhibits these calculations for four construction cost estimates. 6. The estimates of construction costs generally have three components. They are: (1) headend and cable plant; (2) converter box; and (3) "drop and install." This last item is the cost connecting a subscriber to the cable that passes his or her home. One of the headend and cable plant estimates comes from a paper by David Reed. Reed's estimate of $962 is based on an assumed 40% cable penetration rate of homes passed. The actual penetration rate in 1993 was 63%. Adjusting for this yields an estimated headend and cable plant cost of $611 per subscriber. Reed estimates the cost of a converter box at $125 and of drop and install as $50. These latter figures are also used in conjunction with the alternative cable plant and headend estimates. 7. MacAvoy's series of construction cost estimates contains one figure that excludes the drop and install component. The exclusion could be justified on the grounds that at least some cable subscribers pay a separate fee for installation rather than paying for it indirectly via the monthly service charge. To preserve some consistency with the MacAvoy procedure, the current series of construction costs contains one estimate, based on Reed's figures, that excludes drop and install. Accordingly, the "Reed 1" figure in table I-2 is 736=611+125 and the "Reed 2" figure is 786=611+125+50. 8. The other two entries in Table I-2 are labelled "MacAvoy 1" and "MacAvoy 2." They track two of MacAvoy's construction cost estimation procedures. The present calculations are based on data from a different source than MacAvoy used, but the technique is the same. MacAvoy 1 starts with estimates of new build construction costs for 1993 of $646 million and new homes passed of 1.8 million. These figures, along with the 1993 penetration rate of 63% yield an estimated cable plant construction cost of $569.66. Adding to this the converter box and drop and install figures yields $744.66. The MacAvoy 2 estimate begins with the same new build construction cost estimate and with an estimate of 54,900 miles of new plant construction for 1993. Applying an assumed 90 homes per mile and the 63% penetration rate yields an estimate of $207.53. Inclusive of converter box and drop and install, the MacAvoy 2 construction cost estimate is $382.53. 9. Table I-3 contains a series of q ratio calculations, which are also reproduced in the main text of this report. By way of comparison with MacAvoy's earlier work, it is interesting to note that his public market value per subscriber figure of $1698 is lower than the $2326 figure for the current sample of pure cable firms. By contrast, MacAvoy's private market value estimate of $2311 per subscriber is significantly higher than the $1759-$1831 range for 1993 and early 1994. With respect to replacement cost, MacAvoy's median estimate based on construction cost data was $372.50, while the current figure is $444.99. The calculations herein are thus similar to those of MacAvoy, but not precisely comparable. The current sample of pure cable firms differs from that used by MacAvoy, and the construction estimates come from different sources. TABLE I-1 Replacement Data for Four Pure Cable Companies ADELPHIA MERCOM MULTIMEDIA TCA Average Weighted Average Balance Sheet Date March 1993 Year-End Year-End October 1993 Equity (mil) 287.231 9.960 1,274.442 702.838 Liabilities (mil) 1,818.207 29.109 768.20 162.814 Market Value (Total Equity + Liabilities) (mil) 2,105.438 39.069 2,042.732 865.652 Subscribers Per System 1,244,000 37,757 417,333 473,000 Market Value per System $1,692.47 $1,034.75 $4,894.73 $1,830.13 $2,326.28 Net Plant (mil) 398.859 17.946 240.762 106.411 Adjusted Net Plant (mil) 449.469 22.305 290.520 125.311 Other Tangible Assets (mil) 111.135 1.310 163.056 7.259 Replacement Cost (mil) 560.604 23.615 453.576 132.570 Replacement Cost Per Subscriber $450.65 $625.45 $1,086.84 $280.27 $538.81 Other Tangible Assets Divided by Subscribers $89.34 $34.69 $390.71 $15.35 $44.46 Q Value 3.7556 1.6543 4.5036 6.5298 4.4669 Sources: Paul Kagan Assocs., Inc., Cable TV Financial Databook, 58, 70,72, 74 (1994). Subscriber information supplied by MERCOM, Inc. Cable TV Investor, June 7, 1997, at 4. TABLE I-2 Replacement Cost Per Sub Based on Construction Cost Estimates Gross Plant Per Sub Net Plant Divided by Gross Plant Estimates Net Plant Other Tangible Assets Replacement Costs Reed 1 736 .541 398.18 44.46 442.64 Reed 2 786 .541 425.23 44.46 469.69 MacAvoy 1 744.66 .541 402.86 44.46 447.33 MacAvoy 2 382.53 .541 206.95 44.46 251.41 TABLE I-3 q RATIOS Public Market Value Divided by Adjusted Book Value (Four Firms) 4.47 Public Market Value Divided by Adjusted Book Value (Two Firms Common to Current and MacAvoy Sample) 4.52 Public Market Value Divided by Median Replacement Costs (Four Firms) 5.23 Private Market Value (1993 Transactions) Divided by Median Replacement Cost 4.11 Private Market Value (Some 1994 Transactions) Divided by Median Replacement Cost 3.95