Cross-Subsidies in Local Telephone Service

Until the 1980's, local telephone service was tightly regulated. One aspect of regulation was that the Bell telephone companies were allowed to charge relatively high prices for long distance calls in exchange for keeping the price of local access low. Charging a high price to one group of buyers in order to keep prices low to another group is known as "cross-subsidization".

This exercise examines a stylized version of the policy. Suppose you are given the following facts about the market for telephone service and long distance calls in a particular metropolitan area:

• Local service is flat-rate: customers pay a $30 monthly rate to have a telephone line but do not pay any additional fees for local calls.
• The demand elasticity for local service is -0.2 and there are 100,000 customers when the policy is in place.
• Customers pay a per-minute fee for long distance calls. The policy allows telephone companies to charge $0.25 per minute although the cost of a call is really only $0.10 per minute.
• The demand elasticity for minutes of long distance is -1.0 and ten million minutes are consumed with the policy in place.
• The company is currently breaking even on the policy: the amount it spends in subsidies in the local market is exactly equal to its excess revenue in the long distance market.

What is the dollar value of the cross-subsidy? How much does it affect the price of local telephone service? What are the other effects of the policy? Who gains and loses?