Telecommunications deregulation and subadditive costs: Are local telephone monopolies unnatural?

In early 1996, Congress passed the Telecommunications Law, providing the foundation for the opening of regulated local telephone monopolies to competition. One important premise for introducing competition into local telephone markets is that these markets are not (or are no longer) natural monopolies. This paper reexamines the natural monopoly issue using a cost function that controls for firm heterogeneity. Our subadditivity tests suggest that Local Exchange Carriers' (LECs) costs are subadditive when there are controls for unobserved heterogeneity, suggesting that local telephone markets are natural monopoly markets. (C) 2001 Elsevier Science B.V. All rights reserved.