Network Effects at the Origins of Telephony in the US

As the nineteenth century was coming to its end, merchants in Quincy, Illinois were booming. An early railroad bridge over the Mississippi had made the town a regional transportation hub, connecting the flow of people and goods from Chicago and the Eastern cities of the State (Springfield and Peoria), deep into the western frontier. Quincy’s population had grown to 36,000, making it the second largest town in the state. European farmers were rapidly settling in the rural counties around the town.

Being a progressive enclave, Quincy embraced telephony. In 1884, the patent rights of the first telephone company, the Bell System, expired. At that time, despite its high price, the service had 500 subscribers in Quincy, mostly merchants who used the phone to communicate with other merchants in Springfield and Peoria, as well as with other local merchants.1

As the Bell patent rights expired, new independent companies deployed telephone infrastructures in the rural areas, also around Quincy, an area that the Bell System considered non-profitable. These companies built a cable under the Mississippi river and Quincy was connected to Newark, Missouri, 40 miles west, and other 30 towns and villages in the rural area surrounding the town. This evolution was not specific to Quincy. By 1902 there were over 9,000 “independent providers” across the US.2 The result of fierce competition was an impressive expansion of the service (from 270,000 lines in 1894 to 6, 100,000 lines in 1907),3 particularly in rural areas,4 and a substantial reduction in prices.5

The operation of a small independent network was relatively simple. Low-quality infrastructure in the form of copper cables was often installed by farmers themselves. Switching of the calls was more of a challenge. In the early days of telephony, the connection of the calling and the called subscriber was done manually. The larger the volume of users, the more complex and expensive the task became. It was calculated that an increase of 100 subscribers in an exchange would result in an increased cost of $5 for each subscriber.6 Small rural exchanges were easier and cheaper to operate than large sophisticated urban exchanges.

As a result of the competition between the Bell System and the independents, merchants in Quincy faced what is today perceived as a perplexing situation. They had to contract with the Bell System to communicate with merchants in cities back east, and they had to contract with the independent company to communicate with the rural local communities around the city and further west. Even inside the town, two contracts, two monthly fees, and two telephone sets were required to reach all local telephone users.

The reason was that the two existing networks were not interconnected. Again, this situation was not specific to Quincy. By 1907,57 percent of towns with populations above 5,000 had what was called a “dual system”; that is, two or more competing telephone networks. Independent operators had more than 2 million customers and a market share above 35 percent nationwide.7

For a merchant, while having to contract with two (or even three) telephone providers to reach all his customers was a nuisance, it was not worse than contracting with two (or even three) local newspapers to advertise the merchant’s services and reach all the potential audience. Furthermore, competition had reduced prices so severely that contracting with two carriers was often cheaper than contracting at the high rates charged by the monopolist before competition existed. Competition lowered prices and multiplied the penetration of the service, even in rural areas, so the service made it possible to reach a much greater pool of users. Dual service - or, to use today’s terms, “multi-homing” - had its opponents, but it also had supporters among subscribers fearing an increase in rates if the monopoly would return to town.

The main opponent of the dual system was the Bell System, particularly after 1907 when the financier JP Morgan gained control of the group and forced a change of strategy to consolidate the market, reduce competition and put an end to price wars. Morgan had already implemented the same strategy with great financial success in railroads, electricity, and steel.8 The term “morganization” was coined to describe such a strategy.

Morgan hired his most respected manager to run the company: Theodore Vail.9 Vail had made his early career as manager of the railway division in the US Postal Service; he had experience with the telegraph and had already led the Bell System in its early phase, until 1885. Even back in 1885, Vail already understood that the Bell System should develop the largest network as soon as possible, to deter competitors. The main competitive advantage of a telephone network would be the ability to communicate with the largest number of subscribers. “A telephone without a connection at the other end of the line is not even a toy or a scientific instrument. It is one of the most useless things in the world. Its value depends on the connection with other telephones and increases with the number of connections.”10

Vail was fully aware of what is today called Metcalfe’s law: the effect of a telecommunications network is proportional to the square of the number of connected users of the system (n2). This nineteenth-century entrepreneur understood network effects.

However, the board of the Bell System, even at the eve of competition as patent right expired in 1884, preferred dividends for shareholders over network expansion. The early Bell System limited the deployment of the network to dense urban areas, like Quincy, with a large number of merchants ready to pay high prices. Network deployment in rural areas was not the priority.

Vail resigned in 1885 as shareholders were not ready to make the investment to expand the network beyond urban centers. However, the evolution of the market in Quincy and all around the US proved Vail right. When patent rights expired, the aggressive expansion and low prices of the independents threatened the very existence of the Bell System. JP Morgan was to put an end to this situation.

Once reappointed as president of the Bell System in 1907, and with Morgan’s financial support, Vail started an aggressive strategy to undermine the independent competitors. Prices were reduced in competitive markets. Acquisitions were made, both of competing long-distance services (the telegraph giant Western Union) as well as local independent companies, in what has been described as a Genghis Khan strategy - “join the network and share the wealth, or face annihilation”11 - not so different from the growing strategy of other moguls at that time, such as Rockefeller.12

According to Morgan, a man always has two reasons for doing anything: a good reason and the real reason. The good reason for the new strategy of the Bell System is summarized in the slogan “One system, one policy, universal service,” which was repeated again and again in the annual reports of the company and through one of the first and most successful public policy campaigns in corporate history. “It is believed that the telephone system should be universal, interdependent, and intercommunicating, affording opportunity for any subscriber of any exchange to communicate with any other subscriber of any other exchange. [...] It is not believed that this can be accomplished by separately controlled or distinct systems nor that there can be competition in the accepted sense of competition. It is believed that all this can be achieved to a reasonable satisfaction of the public with its acquiescence, under such control and regulation as will afford the public much better service at less cost than any competition or government-owned monopoly could permanently afford.”13

Vail proposed to guarantee that any subscriber would be able to communicate with any other subscriber without the need to contract with different competing carriers. In this way, the system would be universal, not because it would necessarily reach any corner of the country, but because it would allow to reach all the existing subscribers. Full network effects would be exploited by a single entity. Such an objective would be ensured by a single system, with a single policy: one network built around the principles of standardization and centralization.

Universality could have been achievable through the interconnection of the different networks, which would allow a subscriber to communicate with any other subscriber regardless of which company provided the service to each subscriber. The networks could be connected and function, from the perspective of the subscribers, as a single network. This is the situation today. However, the Bell System refused to interconnect with the networks owned by independent companies. Interconnection was perceived as an infringement on the Bell System’s ownership rights for its own infrastructure. It would diminish the value of the company as the competitive advantage of having a larger network would have to be shared with the smaller networks. At the same time, interconnection would limit the freedom of the networks to set the technical standards of the networks, pricing strategies, and so on.

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