The source of natural monopoly in the US local telephone industry

The objective of the paper is to examine the relationship of economies of scale to cost subadditivity and hence, to assess the importance of economies of scale in the U.S. local telephone industry. To accomplish the objective, we estimate a flexible cost function to obtain a measure of scale economies, cost complementarities, and average monopoly gain. The empirical analysis is carried out with pooled cross-sectional time series data for 8 LECs. The interval encompassed by the study is 1951-1991. The empirical results show that both the extent of returns to scale and the proportion of cases that are subadditive are a decreasing function of firm size. On the other hand, cost complementarities have no firm-specific pattern. A large (small) firm's superaddivity (subadditivity) is attributable to small (high) returns to scale. The two largest firms have roughly no cost savings form a monopoly. These results have broad implications for issues of public policy.