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Cornell University Library 
 HE 8778.U5W9 
 
 Standardization of telephone rates, 
 
 3 1924 013 810 613 
 
standardization of Telephone 
 
 Rates 
 
 By 
 
 C. A, Wright 
 Professor of Elecfrtcal Engineering 
 
 and 
 
 D. B. JUDD 
 
 Published by 
 
 The Engineering Experiment Station 
 
 of 
 
 The Ohio State University 
 columbus, ohio 
 
Cornell University 
 Library 
 
 The original of tiiis book is in 
 tine Cornell University Library. 
 
 There are no known copyright restrictions in 
 the United States on the use of the text. 
 
 http://www.archive.org/details/cu31924013810613 
 
TABLE OF CONTENTS 
 
 PAGE 
 
 Section I. Introduction 5 
 
 Faults of the Present System 5 
 
 Objects of Investigation 5 
 
 Assumptions 6 
 
 Proposed Plan 8 
 
 Predicted Results 9 
 
 Section II. Present Method of Determining Telephone Rates 9 
 
 Effects of Monopoly 10 
 
 Lack of Incentive to Efficient Management Offered by Present System 10 
 
 Cost of Valuations and Associated Work 11 
 
 Elements of Injustice in Present Rate System 12 
 
 Fairness of the "Cost-Plus" Rate System as Applied to Groups of 
 
 Telephone Companies 12 
 
 Indefiniteness of Present Rate System 14 
 
 Allocation of Telephone Rates to Communities and Classes of Service. 15 
 
 Section III. Proposed Plan for Determining Telephone Rates 17 
 
 Requirements of a New Rate System 17 
 
 Proposed Solution of the Problem 18 
 
 Effects of Bargaining and Competition 19 
 
 Factors Which Justify Deviation from Average Rates and Correspond- 
 ing Bonuses and Penalties 19 
 
 Proposed Bases for Bonuses and Penalties 20 
 
 Bases for Bonuses and Penalties Already Recognized 22 
 
 Specifications for Bases for Bonuses and Penalties 22 
 
 Section IV. Plant Cost 23 
 
 Difference Between Central-Energy and Magneto Rates 23 
 
 Change in Plant Cost With Area Served 24 
 
 Change in Plant Cost With Calling-Rate ; . 25 
 
 Plant Condition 26 
 
 Section V. Telephone Service 27 
 
 Development , 27 
 
 Calling-Rate 29 
 
 Section VI. Station-Rate Curves 29 
 
 Sources of Information 29 
 
 Method of Plotting Curves 31 
 
 Free-Service 34 
 
 Increase in Telephone Rates With Size of Communities 40 
 
 Comments on Station-Rate Curves 42 
 
 Normal-Cost Basis of Station-Rate Curves 43 
 
 Dependence of Reliability of Station-Rate Curves Upon Free Compe- 
 tition 43 
 
 3 
 
Section VII. Evaluation of Bonuses and Penalties Which Have 
 
 Been Applied 44 
 
 Bonus and Penalty Bases 44 
 
 The Rate Deviation Equation 44 
 
 Limitations on Scope and Exactness of Evaluation of Bonuses and 
 
 Penalties 45 
 
 Possible Methods of Evaluating Bonuses and Penalties 45 
 
 Sources of Information 46 
 
 Bonuses and Penalties Which Have Been Applied 47 
 
 Section VIII. Approximately Just Bonuses and Penalties 53 
 
 Effect of Increasing Miles of Pole Line per Station 53 
 
 Effect of Increasing Average Calls per Day per Station 54 
 
 Effect of Increasing Development 55 
 
 Section IX. Just Bonuses and Penalties 55 
 Classification of Telephone Exchanges in Accordance With Rates and 
 
 Numbers of Stations Operated 56 
 
 The Typical Telephone Exchange 57 
 
 Rate and Bonus and Penalty Changes Required to Raise an Exchange 
 
 from One Rate Class to Another 58 
 
 Effect of Increasing P; Holding C and D Unchanged 58 
 
 Effect of Increasing C; Holding P and D Unchanged 63 
 
 Effect of Increasing D ; Holding P and C Unchanged 67 
 
 Proposed Bonus and Penalty Constants 70 
 
 Section X. Application of Rate-Standardization Plan 70 
 Adjustments Necessary to Care for Changes in Price Level and De- 
 velopments in Art of Telephony 71 
 
 Method of Application of Rate-Standardization Plan 71 
 
 Necessity for Periodical Valuations of Telephone Plant 72 
 
 Additional Probable Requirements in Application of Rate-Standard- 
 ization Plan 73 
 
 Application to Other Public-Utility Rates 73 
 
 Section XI. Summary 74 
 
STANDARDIZATION OP TELEPHONE RATES 
 
 SECTION!. INTRODUCTION 
 
 To protect the telephone companies and the telephone-using 
 public, as well as to regulate rates, nearly every state in the Union 
 has a public-utility or railroad commission. These commissions, 
 in the majority of cases, have the authority to prescribe uniform 
 systems of accounts, to authorize the issue of securities and 
 dividends, to fix and enforce standards of service, and to supervise 
 generally the relations of public utilities with the public. The 
 regulation of the telephone companies by these public-utility com- 
 missions has not accomplished Its full purpose, although it cannot 
 be said that it has been a failure. 
 
 FAULTS OP THE PRESENT SYSTEM 
 
 Apparent faults of the present "cost plus" system of deter- 
 mining telephone rates are: 
 
 1. No incentive is offered the telephone companies to 
 better their service or provide it economically. 
 
 2. The system of regulation is laborious and expensive. 
 It is burdensome both to the public-utility commissions, and 
 to the telephone companies. 
 
 3. The present system of rate determination is not exact 
 and definite. It involves much guesswork. 
 
 4. The present system of regulation does not, in every 
 instance, prevent injustice to telephone subscribers or to tele- 
 phone companies. 
 
 OBJECTS OF INVESTIGATION 
 
 The object of the investigation, which is described in this re- 
 port, was to obtain information and propose methods of correct- 
 ing some of the deficiencies of the present system which have been 
 most subject to criticism. The system of rate determination which 
 is proposed offers a remedy for (1) the lack of incentive to efficient 
 operation, and a partial remedy for (2) the present labor and ex- 
 pense, without emphasizing (3) the indefiniteness, and (4) the 
 injustice of the present system. 
 
 5 
 
This report sets forth also some original methods of investiga- 
 tion which have been effective in the solution of this problem and 
 which may be found useful by others interested in similar problems. 
 
 It does not attempt to decide what elements constitute a fair 
 valuation ; what methods should be followed in dealing with depre- 
 ciation and depreciation funds, or rate of return; whether or not 
 a utility should be taxed or subsidized, or the many other legal 
 and economic problems of rate regulation. It does not attempt to 
 discuss the organization or personnel of the public-utility com- 
 missions or primarily to decide whether original or reproduction 
 or normal costs should be recognized as the fair basis for rate de- 
 termination. The methods suggested, however, do base rates upon 
 normal telephone plant costs; that is, average plant costs over a 
 number of years, rather than the cost of any particular telephone 
 plant. 
 
 This report proposes a system of rate determination in which 
 the rates for any community are the average rates for communities 
 of the size of the community in question, modified by bonuses or 
 penalties. These bonuses and penalties take account of the natural 
 obstacles presented to the telephone company, and the quality of 
 the telephone service made available to the community. 
 
 ASSUMPTIONS 
 
 The following assumptions have been made in the develop- 
 ment of the proposed plan : 
 
 (1) That the purpose of the regulation of the financial 
 policy and service of telephone companies is to obtain the best 
 possible telephone service at the lowest cost which is just to 
 the telephone companies. In order to accomplish this object 
 the state grants the telephone company a monopoly in its com- 
 munity and enforces rules which limit the return on the in- 
 vestment and which prevent speculation. The incentive for 
 providing good service economically, however, is small hecatise 
 there is no chance to obtain an extraordinary return on in- 
 vestment. The "cost plus" system of rate regulation in its 
 present form is not conducive to efficient management. 
 
 (2) That, if the investment in the telephone company is 
 completely safeguarded from the effects of competition in a 
 given operating field, and from speculation, a small guaranteed 
 return on the investment will attract sufficient new capital to 
 the utility to provide necessary service extensions. Under a 
 competitive system, the return over the cost of giving the serv- 
 
 6 
 
ice would be interest plus a profit which is reasonable for the 
 risk involved. If risk is eliminated by permitting only one 
 company to operate in a given field, rates which consist of cost 
 of giving the service plus interest will not only be just but suffi- 
 cient to attract new capital to the enterprise. Under such a 
 condition of monopoly, the element of competition must be in- 
 troduced in some other manner if there is to be any incentive 
 to good management. 
 
 (3) That the telephone service in each community should 
 be self-sustaining. This does not necessarily mean that each 
 class of local service in a community should be self-sustaining. 
 It does mean, however, that neither local nor toll service should 
 be supported in part by the other. Exception to the assump- 
 tion that the telephone service in each community should be 
 self-sustaining might be taken in one possible case — that of 
 very small communities. The allocation of telephone rates to 
 communities and classes of service is discussed in Section II 
 of this report. 
 
 (4) That not only should the relative values of telephone 
 service to the subscribers in the various communities be con- 
 sidered in fixing rates, in addition to the cost of producing the 
 service, but also that they actually have been considered. 
 Telephone companies will contend more strenuously for reason- 
 able rates if the service is good. Under these conditions, the 
 public-utility commissions will more readily grant them, and 
 the public will more willingly pay them. The various indica- 
 tions of the value of the service, however, have not always been 
 considered in their proper relative importance. "Free-serv- 
 ice" between communities, and the general impression of the 
 public-utility commissions of plant conditions have been given 
 too much consideration. 
 
 Among the factors which affect the cost of producing 
 the service are the number of stations served, the calling-rate, 
 and the extent of the territory served. Among those factors 
 which affect the value of the service to the subscribers are the 
 number of stations served, and the quality of the service. The 
 use made of the telephone by the average subscriber, and the 
 telephone development are taken as measures of the quality of 
 the telephone service. These indications of the cost and value 
 of service have not been given sufficient consideration. 
 
 (5) That, the wage-scale will vary only with the size of 
 the community, and that the cost of all telephone plants serv- 
 
ing the same number of stations should be the same, except for 
 the differences due to extent of territory served and the maxi- 
 mum calling-rate. 
 
 PROPOSED PLAN 
 
 The plan for the standardization of telephone rates proposes : 
 
 (1) That if the rates of a sufficiently large number of 
 telephone exchanges serving the same number of stations are 
 averaged, the average rate is the fair one for exchanges of that 
 size. It is the rate which will produce income sufficient to 
 cover the cost of the service, and to provide a reasonable 
 return on the investment. The effects of excessive competition, 
 monopoly, and unfair influence which are in some cases of ad- 
 vantage to the telephone company, and in other cases to the 
 community, will be eliminated if a large number of cases are 
 considered. Typical average rates have been obtained and 
 station-rate curves, showing the relation between these aver- 
 age rates and the numbers of stations served in exchanges are 
 presented in Section VI. 
 
 (2) That when any particular telephone exchange is con- 
 sidered, the natural obstacles which the telephone company has 
 to overcome, and the degree of excellence of its service should 
 be recognized by bonuses or penalties applied to the average 
 rates for exchanges of the size of the one in question. There 
 have been taken as the bases for bonuses and penalties (a) the 
 length of pole line per station, which is an approximate meas- 
 ure of the extent of the territory served by a telephone ex- 
 change; (b) the maximum busy-hour calling-rate per station, 
 which is an approximate measure of the proper size of the 
 central office; (c) the average number of calls per station per 
 day, which is an approximate measure of the cost of operation 
 and of the value of the telephone service to the individual sub- 
 scribers ; and (d) the development in telephones per thousand 
 people in the area served, which is also an approximate meas- 
 ure of the value of the telephone service to the subscribers. 
 Bonus and penalty bases (b) and (c), are combined in this 
 investigation. The desirability of recognizing plant condition 
 and community wealth by bonuses or penalties should also re- 
 ceive consideration. 
 
 The public-utility commissions, the telephone companies 
 and the telephone-using public have consciously or uncon- 
 sciously recognized the above bases for bonuses and penalties, 
 but not to a sufficient extent. A method of determining the 
 
degree to which they have been recognized is presented in this 
 report. Analyses have also been made of typical companies, 
 which show the extent to which they should have been recog- 
 nized. Bases for bonuses and penalties are discussed in Sec- 
 tions III, IV, and V. 
 
 The proposed plan allows the telephone companies the 
 advantages of monopoly in their respective operating fields. 
 The system of bomises and penalties introduces the element of 
 competition with its attendant advantages. Each company 
 competes with others in its class for bonuses. For all bonuses 
 that are granted, penalties must be assessed also, as the 
 bonuses and penalties are based upon the average rates for 
 the class of telephone companies which includes the company 
 in question. 
 
 PREDICTED RESULTS 
 The proposed plan for the standardization of telephone rates 
 offers many advantages. It may be predicted generally: 
 
 (1) That if the public-utility commissions fix average 
 rates corresponding to the numbers of stations served, modi- 
 fied by the bonuses and penalties suggested, their work will be 
 decreased to such an extent that reasonable attention may be 
 given to fixing standards of service and enforcing them. 
 
 (2) That the suggested bonuses and penalties will offer 
 an incentive to the telephone companies to better their service, 
 independent of the efforts of the public-utility commissions. 
 
 (3) That the possession by the public-utility commis- 
 sions, the telephone companies, and the telephone-using public 
 of a knowledge of what are the average, and therefore, just 
 rates, and the just bonuses and penalties will tend to promote 
 harmony in fixing rates. 
 
 The above assumptions, proposed plan, and predicted, re- 
 sults will be discussed more fully in Sections III, IV, V, and X. 
 
 SECTION II. PRESENT METHOD OF DETERMINING 
 TELEPHONE RATES 
 
 Public-utility commissions have generally based rates and 
 amounts of securities and dividends authorized on "fair valua- 
 tions." Ordinarily these fair valuations are estimated costs of re- 
 production, less depreciation, under normal conditions, checked, and 
 in some cases, modified by original costs and the amounts of out- 
 standing securities issued against the property. An equitable rate 
 has been considered to be one which will enable the telephone com- 
 
 9 
 
pany to pay all expenses of operation and provide a return on the 
 invested capital which will attract a sufficient supply of new capital 
 to develop the telephone service to the extent demanded by the 
 public. 
 
 EFFECTS OF MONOPOLY 
 
 The tendency in the last few years has been to eliminate dupli- 
 cation of telephone equipment in the operating areas by granting 
 the companies monopolies in their communities. National and 
 state laws preventing the purchase of one competing company by 
 another have been repealed in many cases. Many consolidations 
 of competing telephone companies have been effected. There has 
 always been a tendency in small communities on the part of dissatis- 
 fied telephone subscribers to organize new and competing telephone 
 companies. Such companies have frequently been unsuccessful 
 financially, and the operation of competing companies has always 
 been harmful to telephone service. The organization of competing 
 companies is now generally prevented by laws which require that 
 a "certificate of convenience and necessity" be granted a new tele- 
 phone company by the public-utility commission before the newly 
 organized company is allowed to operate. When two companies 
 operate in any community, the resulting duplication of equipment 
 increases the cost of the service. The value of the service to the 
 subscribers is greatly decreased because of the decrease in the num- 
 ber of subscribers to which any one subscriber has access. Mon- 
 opoly is, therefore, an advantage in the production of telephone 
 service, but under the existing conditions, the elimination of dupli- 
 cation of telephone plant and service has been accompanied by the 
 elimination of competition. The result has been a tendency of the 
 telephone companies to cease trying to provide the best service 
 economically. 
 
 LACK OF INCENTIVE TO EFFICIENT MANAGEMENT OFFERED BY 
 PRESENT SYSTEM 
 
 This policy of rate-making does not then offer an incentive to 
 the telephone companies to initiate more efficient methods of giving 
 service. If their cost of production is decreased, there is a tendency 
 for rates to be decreased. The result is that efficient management 
 has been penalized. If, through inefficient management, the cost of 
 telephone service is high, the "cost plus" system of rate determina- 
 tion provides the additional revenue necessary, and encourages the 
 management in its inefficiency. 
 
 Public-utility commissions are generally authorized to set serv- 
 ice standards and enforce them; but because of the expense in- 
 
 10 
 
volved in valuations and similar work, there is little opportunity to 
 set and enforce such standards. There is little incentive for the 
 efficient management to provide the best service, when it gets no 
 credit for it, and when the inefficient management provides poor 
 service more conveniently and with less cost. The existing system 
 of rate determination, by guaranteeing a fixed return on the invest- 
 ment, regardless of whether the telephone service is good or poor, 
 rewards inefficient management. It discourages good management, 
 because if the service is good, it prohibits a return greater than 
 this fixed return. 
 
 Each valuation and rate study are an occasion for bargaining 
 and scheming on the part of both the telephone company and the 
 representatives of the public, to persuade the public-utility commis- 
 sion to take action of advantage to one or the other. 
 
 COST OF VALUATIONS AND ASSOCIATED WORK 
 
 One public-utility commission has in some cases allocated the 
 total expense of producing the service to business, residence, and 
 various other classes of service, and apportioned the cost in accord- 
 ance with the use made of the service. The allocation of rates to 
 various classes of telephone service is generally determined by other 
 factors than cost. For example, habit or custom, value to the sub- 
 scriber, and the necessity for controlling the development of cer- 
 tain classes of service influence rate allocation. While it has been 
 argued that an allocation of expense in accordance with cost would 
 give results differing greatly from the allocation determined by 
 the above factors, the cost studies of the commission indicated that 
 this is not the case. It has also been urged that it is difficult or 
 even impossible to allocate correctly the expense. The commis- 
 sion's cost studies indicate that it is not impossible to do this. Fur- 
 ther experience will show whether or not the benefits gained 
 from such a cost study justify its expense. 
 
 Even if no attempt is made to allocate the expense of opera- 
 tion, and the rates are based upon the total cost of producing the 
 service, the expense and inconvenience of this method of determin- 
 ing rates are great. The entire time of many regulating commis- 
 sions is given to making valuations and determining rates, based 
 upon the cost of plant and of operation. Little time is left for 
 setting and enforcing standards of service. If, as has happened 
 during the past few years, the commissions grant many rate in- 
 creases, the suspicion of the telephone-using public that the utilities 
 are favored is aroused. The result is a loss in effectiveness of the 
 commission. 
 
 11 
 
ELEMENTS OP INJUSTICE IN PRESENT RATE SYSTEM 
 
 The existing system of rate-determination is frequently unjust 
 to telephone companies or to subscribers. It has already been sug- 
 gested that it may penalize economical management and good serv- 
 ice, or encourage uneconomical management and poor service. The 
 large and powerful telephone company has an advantage over the 
 small company because of its more able and more numerous per- 
 sonnel, because of its more extensive sources of information, and 
 because of its greater influence in pleading its cause with the 
 public-utility commissions. Of course, such an advantage works 
 an injustice to the small company. 
 
 Telephone companies, even though the return on their invest- 
 ment is limited by public-utility commission regulation, are not 
 now protected from all risks. In times of rapidly advancing prices, 
 public utilities are frequently in financial distress. There are some 
 of them which in the past few years would have been glad to dis- 
 continue their business, and yet they were compelled by public- 
 utility commissions to continue to furnish service at a loss. Public- 
 utility economists have suggested that this condition might war- 
 rant the appropriation by the state, in years which are "fat" ones 
 for the utilities, of part of their income, and financial relief by the 
 state in "lean" years. Prompt recognition by the commissions of 
 the condition of the utilities and relief by rate increases would 
 be a more satisfactory and practicable means of eliminating such 
 injustice. It would, however, require a considerable amount of 
 courage on the part of the public-utility commissions, for they 
 would meet with strong popular disapproval. 
 
 One source of occasional injustice to public utilities is rate 
 regulation and tax assessment by independent state commissions 
 which frequently act independently of each other and of other state 
 and federal government agencies which perform similar functions. 
 
 FAIRNESS OF THE "COST-PLUS" RATE SYSTEM AS APPLIED 
 TO GROUPS OF TELEPHONE COMPANIES 
 
 The justice of fixing as fair rates for telephone service those 
 which will cover the average cost of service and allow a reasonable 
 return on the average investment of a large number of telephone 
 companies of the same size and same general character can be well 
 defended. Under a condition of unregulated competition, the rates 
 of telephone companies would be sufficient to cover the cost of pro- 
 ducing the service, and to provide an adequate return on the in- 
 vestment. This return would consist of interest equivalent to the 
 return on money invested with the greatest possible safety plus a 
 
 12 
 
profit which would vary with the risk of the investment. Under 
 a condition where there was no risk, investors would be willing to 
 invest in the telephone companies, if the rates covered only the 
 cost of service and interest which the safest possible investment 
 would yield. The granting of monopolies to the telephone com- 
 panies in their communities removes much of the speculative risk 
 from the investment. The greatest risk to the success of any such 
 enterprise is that of competition. If the management is efficient, 
 the risks of obsolescence, fire, wind, flood, and other hazards may 
 be provided for, so that a return on the investment which equals 
 interest plus a very small speculative profit, will be sufficient to at- 
 tract new capital to the telephone companies. Under such a condi- 
 tion, the "cost plus" system of rate determination would be a just 
 one for fixing average rates for a number of telephone companies 
 of the same size and same general character. 
 
 The risk of competition has been in large part removed from 
 the telephone business by the various states in order that they may 
 more effectively provide service. The people of these states rather 
 than the telephone companies or telephone subscribers are entitled 
 to the amount equivalent to the resulting decrease in the telephone 
 rates. Actually, the telephone subscriber gets this saving in the 
 form of decreased rates which partly compensate for the over- 
 burdensome taxes on telephone companies. These taxes are assessed 
 by the various states upon the telephone companies and in turn 
 passed along by the companies to the subscribers in the form of 
 increased rates. This gain in economy because of monopoly and 
 the amount of taxation are probably of the same order of magni- 
 tude, so that the total effect of these conditions is that the telephone 
 subscribers pay for the monopoly advantages granted by the states 
 with part or all of the taxes assessed upon the telephone companies 
 by the states. The telephone subscriber pays a rate which may 
 equal what he would pay under a competitive system in which the 
 telephone companies are not taxed. 
 
 Great social benefit to the state results from the development 
 in small communities of telephone service. These taxes, therefore, 
 might well be used to subsidize the telephone companies in small 
 communities. In these communities it is particularly difficult to 
 obtain rates sufficient to pay for the telephone service needed, be- 
 cause the people have not been educated to a realization of the 
 great economic advantage of the telephone, and because the cost 
 per station of construction of a small telephone system is great on 
 account of the long distances involved. In such communities the 
 need for telephones is great and a valuable social service is per- 
 
 13 
 
formed when a telephone system is installed. In such cases, it is 
 sometimes necessary and desirable that aid be extended in the 
 development of the telephone service and it v?ould be more satis- 
 factory and just to aid the telephone company by state subsidy 
 than by financial help from the telephone companies of the larger 
 towns and cities. The provision of such aid, however, is not to be 
 associated with the plan for rate-determination here proposed to 
 any greater extent than with the methods at present followed. 
 
 The present "cost plus" system of rate determination is, there- 
 fore, fair for the average company. The average quality of service 
 of a group of telephone companies may be considered to be of ac- 
 ceptable grade, and it may be assumed that the average efficiency 
 of management is good. When the individual company is con- 
 sidered, however, modifications in rate must be made to take ac- 
 count of unusual conditions. 
 
 INDEFINITENESS OF PRESENT RATE SYSTEM 
 
 An advantage, which may be advanced by some in favor of 
 the present method of determining telephone rates, is that it is 
 exact and definite. If this were so, it would be a strong argument 
 in its favor, but it is not so. Frequently records are not available 
 from which to determine the original costs. It is necessary to 
 guess at many costs in determining the cost of reproduction. The 
 element of "going value" is one which affords much opportunity 
 for differences of opinion. There may sometimes be difficulty in 
 deciding what portion of a telephone plant is used and useful in 
 giving telephone service. 
 
 One public-utility commission, arguing in favor of basing tele- 
 phone rates upon service rendered rather than upon the cost of 
 giving the service, has made the following statement : 
 
 "In the entire scheme of rate-making the valuation of the 
 property is only an aid, an approximation. No matter how ex- 
 pensive or how cheap the property of a utility may be, the 
 public is only interested in service, and for that service, it 
 should pay a fair price; but it is absurd to contend that the 
 enormous sum of money invested in antiquated equipment, fur- 
 nishing inadequate service by ancient methods discarded in the 
 intelligent progress of the art, entitle a company to higher 
 rates, than better service furnished for less money invested 
 in more cheap, simple and up-to-date equipment. 
 
 "The factor of management has more to do with earnings 
 than all the hypothetical reproduction and conjectural depre- 
 ciation compiled by all the engineers and commissions that 
 have considered them. The public cannot be expected to pay 
 rates on unnecessary property, extravagant construction, im- 
 provident investment, or excessive facilities not yet demanded." 
 
 14 
 
In regard to the "reproduction less depreciation" theory of 
 determining rates urged by the telephone company in question, the 
 commission stated : 
 
 "This method of determining value usually included per- 
 centages for engineering service never rendered, hypothetical 
 efficiency of unknown labor, conjectural depreciation, opinions 
 as to the condition of the property, the supposed action of the 
 elements, and of course its correctness depends upon whether 
 superintendence was wise or foolish, the investment improvi- 
 dent or frugal. It depends upon probability rather than 
 reality; it is based on such half truths that it bears only re- 
 mote resemblance to fact, and rises at best to the plane of a 
 dignified guess." 
 
 While many public-utility commissioners and telephone men 
 may not entirely agree with this statement, it is a strong indication 
 of the indefiniteness and inexactness of this method of determining 
 rates. 
 
 ALLOCATION OP TELEPHONE RATES TO COMMUNITIES AND 
 CLASSES OP SERVICE 
 
 If only one class of telephone service were furnished by a tele- 
 phone company, each subscriber would pay an equal share of the 
 operating revenue of the company; but telephone companies gen- 
 erally have to supply direct or party-line business and residence 
 service at flat rates, or in some cases at measured-service rates, 
 rural or farm-line service, postpayment or prepayment pay-station 
 service, and private-branch exchange service. Extension sets and 
 extension bells must be provided where required and provision 
 must be made for "switching" lines of co-operative or farmers- 
 mutual companies which own and maintain their own lines. 
 
 Two-number and particular-person toll or long-distance serv- 
 ices which require the adoption of an initial period and rate, and 
 a rate for conversations which extend beyond the initial period 
 must be offered. Special rates must be given at night to induce 
 the public to use long-distance lines during hours of "light load." 
 Report charges must be made to prevent unfair use of telephone 
 service by means of a prearranged code of reports. 
 
 It is apparent that it is not an easy problem to determine such 
 a rate for each of the above classes of service, that no injustice 
 will be done any of the subscribers, and that the total operating 
 revenue will be sufficient for the continued operation of the tele- 
 phone company. 
 
 It has been assumed in this plan for rate determination that 
 the telephone service in each community should be self-sustaining. 
 
 15 
 
Each business or industry should be self-supporting. A test of 
 its value to its community is the willingness of consumers to pay 
 enough for the commodity to support the industry. A telephone 
 company should, according to this point of view, be self-supporting. 
 This has not always been the case. There are cases where telephone 
 systems have been supported in part by systems elsewhere, so that 
 competition might be destroyed by providing service at low rates 
 or so that telephone service might be developed in a small com- 
 munity the residents of which have not realized the value of the 
 service. 
 
 Rural service, for example, was developed under unfavorable 
 conditions. Most companies found it hard to induce farmers to 
 buy telephone service and, as they were anxious to develop this 
 service, they made rates which were very low. In many cases, 
 service of this kind is not nearly self-sustaining and is being paid 
 for largely by the city subscribers. 
 
 It might appear, on first thought, that in any community each 
 class of telephone service should be self-supporting, but this is not 
 always the case. Each class of service should eventually support 
 itself. If a class of subscribers will not pay rates sufficient to cover 
 the cost of the service provided, another class of service should be 
 developed for them which will be self-supporting. However, it is 
 frequently necessary to give a class of service temporarily at such 
 a rate that it is not self-supporting in order that it may be developed 
 to the point where it will pay for itself. In any attempt to apply 
 this principle it must be remembered that it is practically impos- 
 sible to allocate justly certain elements of cost to the various classes 
 of service. The development of some classes of service, such as 
 residence, increases the value of other classes of services, such as 
 business, so that the cost of such development should be distributed 
 in proportion to the increased value — in so far as it is possible to 
 determine it — over the various classes of service benefited. It is 
 impossible in most cases to determine, except approximately, this 
 increased value. This plan for rate-determination is not in any 
 way dependent upon the possibility of so allocating local telephone 
 rates. 
 
 The cost of toll or long-distance service is generally affected by 
 the distance over which the connection is established, the length of 
 time the equipment is in use during the call and the operating cost 
 of establishing the connection. Sometimes the length of the con- 
 nection or the route affects the operating cost, as when the services 
 of a "through" operator are required, or when supervision by two 
 operators instead of one is necessary. 
 
 16 
 
There has been much discussion as to whether toll rates should 
 cover the entire cost of toll calls from subscriber to subscriber, or 
 only from toll-switchboard to toll-switchboard. If, as has been 
 done by at least one public-utility commission, the subscriber to 
 subscribe!* cost is assumed, it will be found that in maijy cases toll 
 service is not self-sustaining. 
 
 If toll service is partly supported by exchange rates higher 
 than necessary to cover the cost of exchange service, the develop- 
 ment of exchange service may be retarded, or if toll rates are too 
 high, toll development may be retarded. An extreme case of in- 
 justice is that of communication in which "free long-distance serv- 
 ice" to other communities is provided. The local exchange rates 
 are higher for all subscribers in order that a few subscribers may 
 have the benefit of such free long-distance service. 
 
 Toll rates which are not self-sustaining might be justified in 
 some cases because toll service is an asset which increases the value 
 of the telephone service to all exchange subscribers. 
 
 Public-utility commissions, acting for the public welfare, have 
 in many cases ordered telephone companies owning and operating 
 toll lines to permit other companies to route calls over these toll 
 lines. In such cases, in justice to the companies owning the toll 
 lines, the commissions have prescribed rental rates which would 
 make this service self-sustaining. 
 
 If local and toll service are not each self-sustaining, some com- 
 munities by paying more than the cost of the toll service they use, 
 might indirectly partly support the local service in other communi- 
 ties. It is assumed in this plan for rate determination that the 
 rates for local and toll service should be mutually independent. 
 
 It may be seen that, in addition to cost, the rate for each class 
 of local and toll telephone service is affected by habit and custom, 
 value of the service to the subscriber, competition and unfair in- 
 fluence, the necessity for developing various classes of service and 
 for preventing waste and unfair use of service, and the necessity 
 for making the method of charging simple and easily understand- 
 able to the average subscriber. 
 
 SECTION III. PROPOSED PLAN FOR DETERMINING 
 TELEPHONE RATES 
 
 REQUIREMENTS OP A NEW RATE SYSTEM 
 The method of determining telephone rates by providing that 
 they shall be high enough for each telephone company to cover the 
 cost of giving the service and provide sufficient return on the in- 
 vestment to attract new capital has been adopted by law in many 
 
 17 
 
states. If any other plan is to be adopted, it would have to be 
 shown that it promises to be more logical and fair and definitely- 
 better than the plan followed at present. 
 
 Any new system of rate determination or any modification of 
 the present, system should tend to correct the apparent faults in the 
 present system which have been suggested. It should accomplish 
 the following results : 
 
 (1) It should offer an incentive to telephone companies to 
 provide the best possible telephone service and to provide it as 
 economically as possible. 
 
 (2) It should make less burdensome and expensive the 
 work of the public-utility commissions and the telephone com- 
 panies. 
 
 (3) It should not increase the number of conditions which 
 work injustice to the telephone companies or telephone sub- 
 scribers. 
 
 (4) It should not involve any more guess work than the 
 present system of rate determination. 
 
 PROPOSED SOLUTION OF THE PROBLEM 
 
 Various telephone men have suggested that rates for tele- 
 phone service should be standardized, the number of stations served 
 in a community determining the rate for the various classes of serv- 
 ice, and that unusual conditions or service should be recognized by 
 bonuses or penalties applied to individual cases. The population of 
 the exchange area and the calling rate might be suggested also as 
 fundamental bases of standardization. The fundamental basis for 
 the standardization of telephone rates should represent natural con- 
 ditions which confront the telephone companies and over which they 
 have no control. It should be independent of the effectiveness of 
 the management of the companies. The calling-rates, whether 
 maximum or average, are not independent of the effectiveness of 
 management, but are affected by it. They are, therefore, not a 
 satisfactory basis of comparison. The population of the exchange 
 area represents more nearly than any other single condition the 
 problem presented to the telephone companies; but population is 
 sometimes not easily available, especially in the cases of small 
 towns where a large proportion of the subscribers live in rural dis- 
 tricts. The number of stations served in an exchange area while not 
 quite as satisfactory in some respects as total population has the 
 great advantage of being always available. Hence it is the most 
 desirable basis of comparison. 
 
 18 
 
EFFECTS OF BARGAINING AND COMPETITION 
 
 In some communities the telephone company may be able, by 
 ability to bargain which is above the average, to gain the advantage 
 in fixing the rates, while in other cases the community may gain the 
 advantage. Monopoly or unfair influence, the disposition to prof- 
 iteer, the value of the telephone to the subscribers, and the ability 
 of the subscribers to pay fair rates all affect the rates, sometimes 
 to the advantage and sometimes to the disadvantage of the com- 
 pany. If a sufficient number of cases are considered, the advantage 
 will be on the side of the telephone company as often as it is against 
 it, and the average rates for a group of telephone exchanges of a 
 given size may be assumed to be independent of inequalities in 
 bargaining power. In towns, where there are competing telephone 
 companies, the bargaining power of the companies is greatly de- 
 creased and the rates are consequently low. In such cases the value 
 of the service is decreased, and the communities pay rates which 
 are in proportion to the value of the service they receive. 
 
 Closely associated with bargaining power are the effects of the 
 character of the community and the grade of service it wants and 
 is willing to buy. Communities of the same size may differ indus- 
 trially, but this is unusual. Generally, such differences correspond 
 to differences in the sizes of communities. Farming communities 
 are usually small, while the industries are usually confined to the 
 large cities and towns. The grade and amount of service demanded 
 vary regularly with the sizes of communities — rapidly for small 
 communities, and more gradually for large communities. In so 
 far as such conditions are concerned, then, it may be assumed that 
 the average rate is the fair rate for communities of the size under 
 consideration. 
 
 FACTORS WHICH JUSTIFY DEVIATION FROM AVERAGE RATES, AND 
 CORRESPONDING BONUSES AND PENALTIES 
 
 If the plant and traffic conditions with which a telephone com- 
 pany has to contend and over which it has no control are such as 
 to make the investment and production costs — the sum of which are 
 the total cost of producing the service — higher or lower than the 
 average, the telephone rates should be correspondingly higher or 
 lower than the average. If also the service is very good or very 
 poor, the compensation of the telephone company for that service 
 should be correspondingly high or low. Bonuses or penalties should 
 be applied to the average rates to give rates which are just to indi- 
 vidual telephone companies and to the communities they serve. 
 The value of this rate-standardization plan depends upon the possi- 
 
 19 
 
bility of obtaining bonuses and penalties which may be toeighted 
 properly and fairly, which may be evaluated for individual cases 
 without the expense and inconvenience of the present method of 
 evaluating telephone plants, and which will take account of ab- 
 normal plant and service conditions. If, incidentally, these bonuses 
 and penxilties are closely associated with the elements of service 
 given the subscribers and emphasize good service, the rate stand- 
 ardization plan will also result in an improvement in the telephone 
 service of all communities. 
 
 PROPOSED BASES FOR BONUSES AND PENALTIES 
 
 Unusually high plant and operating costs, which are not the 
 fault of the management, peculiar characteristics of the community 
 which make it difficult to give service, and other natural obstacles 
 with which a telephone company has to contend are one natural 
 basis for bonuses, or penalties. The service given is the other 
 basis which should be recognized. Good or poor service may be 
 recognized by analyzing service, by weighting its various elements 
 more or less arbitrarily according to the judgment of representa- 
 tives of the telephone companies and the public, and by comparing 
 the elements of service of the individual companies with those 
 weighted elements. It may be recognized also by the results of 
 good or poor service as shown by the telephone development in a 
 community, and the average use made of the telephone by the 
 subscribers. 
 
 The latter basis for judging service is the best. An evaluation 
 of service by any analysis of service from its elements would set 
 up a standard which would not develop as service conditions change. 
 It would be too rigid and inelastic. The various elements of service 
 would have to be arbitrarily weighted by representatives of the 
 various interests concerned. Such a method would afford much 
 opportunity for difference of opinion both in preparing a standard 
 table of weighted elements of service, and in applying this table 
 to individual cases. The attempted use of such a method of recog- 
 nizing the degree of excellence of service would result in much 
 friction. Table I shows the various elements of service which would 
 have to be considered. A discussion of these elements of telephone 
 service may be found in Circular No. 9, Engineering Experiment 
 Station, The Ohio State University. 
 
 It may be contended that assigning bonuses and penalties on 
 the basis of the above elements of service would be more direct and 
 for that reason more satisfactory. Although it might be practicable 
 to apply bonuses or penalties based on plant and operation elements 
 
 20 
 
of service, the results of good management are much more intan- 
 gible, and it would be difficult to weight and apply the corresponding 
 elements of service directly. 
 
 Attention may also be called to cases which will occur in which 
 there will be injustice done to telephone companies, as for example, 
 those of communities where the provision of a high grade of service 
 has not been followed by high development or a high average call- 
 ing-rate. Such a condition of unfairness is more likely to exist 
 temporarily after the provision of the high grade service than 
 permanently, unless the telephone company has used poor judg- 
 ment in providing a better grade of service than the community 
 desires or is able to pay for. In such a case the telephone company 
 would not deserve a bonus. 
 
 TABLE I. 
 
 ANALYSIS OF TELEPHONE SERVICE 
 
 ADEQUATE 
 
 TELEPHONE 
 
 PLANT 
 
 EFFECTIVE 
 
 TELEPHONE 
 
 OPERATION 
 
 GOOD 
 
 MANAGEMENT 
 
 Good Telephone 
 Transmission 
 
 ' Loudness 
 Quality 
 
 Freedom from interference 
 Education of public in regard to neces- 
 sity for good equipment 
 
 Adequate Facilities 
 
 Simplicity of Substation Equipment 
 
 Reliability of Equipment 
 
 Safety 
 
 Permanence 
 
 Accuracy 
 
 Continuity of Service and Reliability of Operation 
 
 Speed 
 
 Assurance of Attention 
 
 Courtesy and Form 
 
 Secrecy 
 
 Service Inspection 
 
 Education of Public in Regard to the Use of Telephone 
 
 f Accuracy 
 Business Methods \ Promptness 
 [ Simplicity 
 
 (Adequate depreciation reserve 
 Proper control of securities 
 Care and Training of Employees 
 
 Citizenship 
 
 r Progressiveness 
 
 J Appearance of p. 
 
 1 Regard for rights of public 
 
 u 
 
 Publicity 
 
 Appearance of plant 
 
 Regard for rights of i 
 
 Local interest and cooperation 
 
 Condition of plant 
 
 Methods of operation 
 
 Service objectives and results obtained 
 
 Reasons for rates 
 
 21 
 
The application of development and average use of the tele- 
 phone by subscribers, as bonus and penalty bases, may be well 
 justified. It makes necessary only two bases for service bonuses 
 and penalties and avoids the complicated process of weighting serv- 
 ice which would result from assigning bonuses and penalties on the 
 basis of service elements. The conditions which would warrant 
 bonuses and penalties would be easily obtainable. Development and 
 average calling-rate show the final result of good or poor service, 
 and it is the result that is important rather than the factors which 
 produce the result. 
 
 BASES FOR BONUSES AND PENALTIES ALREADY RECOGNIZED 
 
 The necessity for bonuses or penalties for unusual plant con- 
 ditions or service has been recognized to a certain extent by public- 
 utility commissions. They have frequently granted rates in excess 
 of those which are normal for communities of the size in question 
 because of a general impression that service is unusually good, be- 
 cause the plant conditions encountered are unusually severe, because 
 the plant has been maintained in exceptional condition, and, in 
 many cases, because of "free service." 
 
 The Interstate Commerce Commission and various telephone 
 statisticians in their reports have recognized the importance of 
 pole-line, wire-miles, average-calls, and development. However, 
 no attempt has been made to make use of them as bases for 
 bonuses and penalties in fixing telephone rates. 
 
 SPECIFICATIONS FOR BASES FOR BONUSES AND PENALTIES 
 
 The following specifications should be observed in choosing 
 bases for bonuses and penalties : 
 
 (1) The final results of good or poor telephone service, 
 that is, the amount of service sold and quality of service 
 rather than any specific elements of service, should be used 
 as bases for bonuses and penalties. 
 
 (2) Unusual plant conditions over which the telephone 
 company has no control should be used as bases for bonuses 
 and penalties. 
 
 (3) The bases for bonuses and penalties should be few 
 in number. 
 
 (4) They should be easily determined from existing rec- 
 ords, or records which it is otherwise to the advantage of the 
 telephone company to keep. 
 
 (5) They should be general in character, and indicative 
 of plant and service conditions as a whole. 
 
 2Z 
 
The choice of the bases for bonuses and penalties is altogether 
 a matter of jvdgment. It can be decided only by the vote of large 
 numbers of informed and interested parties. The four bases sug- 
 gested in this bulletin are those which from this investigation seem 
 most reasonable. However, if additional bonus and penalty bases 
 may be found to be necessary, they will not prevent the successful 
 application of this rate-standardization plan. 
 
 The cost of producing telephone service in general determines 
 the lower limit of the rates paid for service. The upper limit is 
 determined by the value of the service to the telephone-using public. 
 The rates obviously cannot be permitted to exceed this upper limit. 
 Attempts to charge "all the traffic will bear," generally result in 
 rates which are greater than the traffic will bear. While the rates 
 have too frequently been so low that they would not cover the cost 
 of service, care should be taken that they are not permitted by 
 means of bonuses in any case to approach the upper limit, or "all 
 the traffic will bear." In such a case, the granting of rate bonuses 
 to a telephone company might defeat the intended purpose by dis- 
 couraging the use of the telephone. Moderation should be observed 
 in the application of bonuses and penalties. 
 
 SECTION IV. PLANT COST 
 
 DIFFERENCE BETWEEN CENTRAL-ENERGY AND MAGNETO RATES 
 
 The cost of central-office equipment should generally not vary 
 greatly from the average for each group of telephone companies 
 operating the same number of stations. If there is any difference, 
 it would probably result from a difference in the maximum calling- 
 rate or peak-load demand upon the telephone exchange. Exceptions 
 which occur are cases where central-energy and magneto exchanges 
 serve communities of the same size. In an investigation of one 
 large group of telephone companies — Group 4 of the Ohio telephone 
 companies — it was found that the point of change on the station- 
 rate curves — which will be discussed in Section VI — from magneto 
 to central-energy switchboards, is fairly sharp and definite at 1000 
 stations. If average curves are plotted separately for the magneto 
 and central-energy stations, a discontinuity in the curve at the 
 point of change may reasonably be expected. If the curves are 
 prolonged at the point of discontinuity so that they will overlap 
 as in Figure 1, they might well show what additional rate a central- 
 energy exchange in a magneto group should be allowed, or what 
 should be the decrease in the rate of a magneto exchange in a 
 central-energy group. This difference would be due to the differ- 
 
 23 
 
ence in value of the two kinds of service as well as to the difference 
 in cost. In the case of Group 4 of the Ohio telephone companies, 
 the two curves were continuous. This result indicates that there is 
 no difference in cost and value. The same reasoning might be 
 applied to ringing equipment, but in this case also, there were no 
 discontinuities, indicating that the differences in rates due to ring- 
 ing equipment are not important. 
 
 Figure 1 
 
 CHANGE IN PLANT COST WITH AREA SERVED 
 
 There is a considerable amount of variation in the cost of out- 
 side plant within groups of companies operating the same numbers 
 of stations, due to area served and unusual construction difficulties. 
 Miles of pole line per station, or number of poles per station, pref- 
 erably the former, may be taken as a measure of the area served, 
 and as a basis for a bonus, or penalty. Wire miles has received 
 consideration as a bonus and penalty base, but it is not a good 
 measure of the area served by a telephone company. Area itself 
 might be used directly, but there would be considerable difficulty 
 in defining the area served. One or two stations in an otherwise 
 undeveloped area might serve as an excuse on the part of a tele- 
 phone company for claiming a bonus because of the large territory 
 it serves. Miles of pole line per station is the best measure of the 
 territory actually served by a telephone company. 
 
 24 
 
In cities where a large proportion of the circuits is under- 
 ground, miles of underground conduit per station, modified by a 
 factor which will properly weight it relatively to the pole line, 
 should be added to the miles of pole line per station. As this in- 
 vestigation has not considered the largest communities, miles of 
 pole line per station only has been used. 
 
 Among. the possible unusual construction difficulties may be 
 mentioned the character of the ground. The cost of extending 
 lines through a hilly and rocky country is greater than through a 
 country where the ground is easily workable. It often happens that 
 in cases where the cost of construction is greatest, the people are 
 least able to pay adequate telephone rates, as for example, in a 
 rocky and barren country, where it is difficult to farm successfully 
 and difficult to construct lines. 
 
 CHANGE IN PLANT COST WITH CALLING-RATE 
 Maximum busy-hour load or maximum calling-rate may also 
 be taken as a cost bonus or penalty, independent of the average 
 calls per station which is later suggested as a value bonus or 
 penalty. It determines the cost of part of the central-office equip- 
 ment and is an indication also of the cost of operating the switch- 
 board. An approximate measure of this factor is the maximum 
 number of operators' positions in use. However, as the number of 
 operators' positions in use is. not independent of the efficiency of 
 operation of the telephone plant, it is not as desirable as a bonus 
 and penalty base as the maximum busy-hour load as determined 
 by a peg-count. In the evaluation of bonuses and penalties in this 
 report, both cost and value elements are cared for by one bonus 
 or one penalty which is determined by the average calls per station. 
 This bonus or penalty is approximately the sum of the two bonuses 
 or two penalties obtained by considering the cost and value factors 
 separately. 
 
 An examination of the maximum busy-hour calling-rates and 
 average calling-rates of a limited number of exchanges, for which 
 information in regard to maximum busy-hour calling-rates could 
 be obtained, indicates that they vary approximately in the same 
 proportion, or, in other words, that the amplitude but not the form 
 of the average daily traffic-curve for the year varies with the com- 
 munity. This statement is probably more nearly correct when com- 
 munities of the same size and type are compared than when the 
 comparison is made between those of different sizes and types. In 
 the examination referred to above, all of the communities were of 
 about the same type, that is, served by from 1000 to 3000 stations. 
 If maximum busy-hour load were used as a basis for a bonus or 
 
 2C 
 
penalty, it should not be difficult for public-utility commissions to 
 induce the telephone companies to inaugurate the use of peg-counts 
 in cases where they were not already in use. 
 
 The busy-hour calling-rate and the average calling-rate may 
 both be affected by conditions such as the industrial character of 
 the community or the proportion of foreign-born persons in the 
 population and the nationality of the foreign-born population. For 
 example, the use of the telephone by a French quarter of a city is 
 likely to be much greater than its use by a Scandinavian quarter 
 of the same size. 
 
 PLANT CONDITION 
 
 A valuable element of telephone service is the assurance to the 
 subscriber that the service will be continuous. The condition of the 
 telephone plant in a large measure determines the extent of this 
 assurance. It may in many cases be possible to estimate the con- 
 dition of the plant from a statement of its age, and statements of 
 depreciation reserve, and of issues of stocks and bonds. Accrued 
 depreciation may be the basis for a penalty or bonus. 
 
 If a plant is over-built to a reasonable extent, it would prob- 
 ably be just to allow a bonus. A plant should be over-built suffici- 
 ently to make it possible to furnish service to new subscribers with- 
 out delay. Records of applications and time necessary to furnish 
 service might be used to advantage as an indication of the condition 
 of the plant. An over-built condition of a plant may be regarded as 
 the opposite of a depreciated condition and one bonus and penalty 
 base may apply to both conditions. 
 
 A reasonably over-built condition is more desirable in the case 
 of a telephone company than in the case of an electric light and 
 power company or other type of public utility. If there is an unus- 
 ual demand for street-railway transportation, it may be met by 
 crowding passengers into the cars, and the additional equipment 
 necessary may be provided after the increased demand has devel- 
 oped. New users of electric light and power, gas, and water service 
 may generally obtain connection to already existing supply circuits 
 or mains. Additional equipment may be provided in the central- 
 station or gas or water plant when opportunity permits, but the 
 additional plant does not generally have to be provided before the 
 new users are supplied with service. However, each telephone sub- 
 scriber, or in the case of party-line service, each small group of 
 subscribers, requires a circuit to the central office for his sole use. 
 Such a circuit must be available before a new subscriber can be 
 supplied with service. During the extreme conditions which have 
 existed in the past few years many telephone companies have at- 
 
 26 
 
tempted to meet the situation by making party lines of direct lines, 
 or in some cases even by making ground-return circuits of metallic 
 circuits. The results have been most unsatisfactory to both tele- 
 phone companies and subscribers. In order to supply service 
 promptly to new subscribers, a telephone plant must be over-built. 
 In this investigation, bonuses or penalties have not been allowed 
 for plant condition or facilities. They may be considered to be 
 included in development bonuses and penalties. People will not 
 subscribe to telephone service if they feel that it will deteriorate 
 because the plant is not maintained and they cannot subscribe to 
 it unless there are adequate plant facilities. However, these ele- 
 ments of service are important and it may be possible that they 
 should be the basis for a separate bonus or penalty. 
 
 SECTION V. TELEPHONE SERVICE 
 
 The average excellence of telephone service increases as the 
 community increases in size, but in each group of telephone ex- 
 changes serving the same number of stations there are individual 
 exchanges to which bonuses or penalties are due because of the 
 quality of their service. 
 
 DEVELOPMENT 
 
 The degree to which people buy telephone service and the 
 degree to which they use it are approximate measures of its ex- 
 cellence. The development in stations per thousand people shows 
 not only how aggressive the management of a company has been 
 in selling telephone service, but also the quality of service which 
 has been maintained. The better the service the easier it is to sell. 
 It may be difficult in the cases of small communities to ascertain 
 how great a rural population might possibly be served by a tele- 
 phone company. While not entirely satisfactory, the development 
 within the town or city might be used, as a measure of the total 
 development. In the cases of the larger cities, the proportion of 
 subscribers who are rural subscribers is small, and will not greatly 
 affect the development. 
 
 It is much less difficult to obtain the additional stations in a 
 community where the development is not high than" in an already 
 well-developed territory. The last subscribers obtained are gen- 
 erally the hardest to obtain. 
 
 It might be argued that increasing the development is the 
 same, as far as rates are concerned, as putting the exchange in a 
 higher class, on the station-rate curve. This is not the case. The 
 value element of the service, indicated by the development for 
 
 27 
 
which a bonus or a penalty is given, does not result from the num- 
 ber of stations served. This number of stations is taken account 
 of by the position of the exchange on the station-rate curve. The 
 value element of the service results from the higher grade of serv- 
 ice produced. Because the service in itself is better, and because 
 the subscriber may, if he desires, obtain connection with a greater 
 number of telephones, the telephone company can sell more tele- 
 phone service, but the latter element of value is otherwise recog- 
 nized and the bonus should be applied only for the good service. 
 
 If development were used as a basis for a bonus or penalty, it 
 would not be difficult for a public-utility commission to obtain infor- 
 mation in regard to the population, the corresponding number of 
 stations, and the development of each exchange area in its state. 
 
 The provision of "free service" to neighboring towns has been 
 recognized as having value to the subscribers, and public-utility 
 commissions have allowed increased rates because of free-service. 
 Free-service has the same kind of value as increased development, 
 but the value per given percentage of increase in subscribers with 
 whom it is possible to get connection is not as great as in the case 
 of an increase in development. There is not as free a use of serv- 
 ice over the free-service lines as in the case of inter-office trunks 
 in an urban exchange area, because it is less convenient to use the 
 facilities provided for free service than to use those provided for 
 normal local service, and because there is less community interest 
 among subscribers in neighboring communities than among those 
 in the same community. The method followed in weighting free-' 
 service is explained in the discussion of the curves of Figures 2 to 
 7 (Section VI). 
 
 When there are two competing telephone exchanges in a com- 
 munity, the rates tend to decrease because of the competition, as 
 mentioned above, and incidentally the service is worth much less. 
 If rates were determined by modifying the average rate in accord- 
 ance with development, the development of each exchange might be 
 considered either as the total stations of the community divided 
 by the total population (expressed in thousands) of that commu- 
 nity, or as the stations of that exchange divided by the total 
 population of the community. In the latter case, which is the more 
 just, the rates will be low because the development is low, and the 
 rate of the new exchange will be the lower of the two if it has fewer 
 stations than the other. In the other case, the rates will be high 
 because, on account of the competition, the development will be high. 
 
 28 
 
CALLING-RATE 
 
 Not only may the excellence of service be measured by the 
 proportion of total population who buy telephone service, but also 
 by the extent to which each subscriber uses his telephone. The 
 number of calls per subscriber may be computed from the estimated 
 number of calls per year, or if the distribution of calls throughout 
 the day and year is regular and known, from the busy-hour calling- 
 rate. A rough measure of the busy-hour calling-rate is the number 
 of operators' positions occupied; but, as suggested above, this is 
 not entirely satisfactory because it is not independent of the effici- 
 ency of the operating force or management, as is the calling-rate. 
 Even if the calling-rate is low, the number of operators' positions 
 occupied may be high because of inefficiency of operators or of 
 the switchboard in use. 
 
 The busy-hour calling-rate is more nearly a measure of the 
 peak-load demand on the telephone exchange because it is ap- 
 proximately proportional to positions of the central-office switch 
 board and the number of operators required to operate the switch- 
 board, while the average calling-rate per station is not so good. a 
 measure of the demand on the exchange but is probably a better 
 measure of the satisfaction given the subscribers by the service. 
 Estimates of the average number of calls per month or per year are 
 generally available, while very few of the small telephone com- 
 panies have ever taken peg-counts, which would show their busy- 
 hour calling-rates. However, if required by commissions, busy- 
 hour calling-rates could be obtained without great difficulty, and 
 would generally be a more satisfactory means of measuring the use 
 of the telephone by the subscriber than the estimates of numbers 
 of calls. 
 
 SECTION VI. STATION-RATE CURVES 
 
 SOURCES OF INFORMATION 
 Copies of the data sheet shown on page 30 were sent to the five 
 hundred and twenty-five Class A, B, C, and D telephone companies 
 in Ohio. The replies gave reliable information in regard to three 
 hundred and six telephone exchange areas many of which, however, 
 provided only a few classes of service. In addition, many data 
 sheets were received on which the information was inadequate for 
 the purpose of this investigation or unreliable because the intention 
 of the questions had not been understood. Portions of this infor- 
 mation were checked by information obtained from the 1920 "An- 
 nual Report of the Public Utilities Commission of Ohio," "Tele- 
 phony's Directory of the Telephone Industry," and the records of 
 
 29 
 
the Public Utilities Commission of Ohio. When all of this informa- 
 tion was arranged and examined, it was found that enough infor- 
 mation was in hand to plot reliable curves showing the variation 
 of telephone rates with the number of stations served by telephone 
 exchanges. 
 
 There are in Ohio many groups of one city surrounded by a 
 number of small towns and villages which present telephone condi- 
 tions which differ from the general conditions. In each of these 
 groups, free long-distance service or "free-service" between com- 
 munities is more highly developed than it is in general. The service 
 is of a higher grade because it is given in cities, and towns and 
 villages, the standards of service of which have been influenced by 
 
 Fill Out One of These Sheets for EACH Town or City in Which Your Telephone 
 
 Company Operates 
 
 Telephone Company. .Town 
 
 Number of stations in town Population of town - 
 
 Number of exchanges in town Miles of pole line 
 
 Plant valuation (if available) Annual operating expense 
 
 Capital stock JBonds — 
 
 Kind of system (magneto, central energy, or automatic) _ 
 
 Average number of stations on rural lines On party lines... 
 
 Type of ringing _ _ 
 
 Towns to which free service is given _ ...._ 
 
 Conditions which make plant valuation or operating expenses high and which 
 would therefore warrant high rates ., 
 
 Class of Service 
 
 Number of Stations 
 
 Eate 
 
 Business, 1-party...... 
 
 Business, 2-party. 
 
 Business, 4-party. 
 
 Business, Rural 
 
 Residence, 1-party... 
 Residence, 2-party... 
 Residence, 4-party... 
 
 Residence, Rural 
 
 Switching 
 
 Extensions 
 
 P. B. X. Trunks - 
 
 P. B. X. Extensions.. 
 P. B. X. Boards 
 
 Data Sheet 
 
 30 
 
the cities. Business service is relatively more important, and the 
 rates are higher because of the higher grade of service and the 
 more highly developed free-service between communities. These 
 groups of communities have been collected in this investigation 
 in Group 1. 
 
 In Group 2 are included cities and towns in which, similarly, 
 the service is of high grade and the rates proportionally high, but 
 in which free-service is not as prevalent as in the cities and toAvns 
 of Group 1. The equipment and service methods of Group 2 are 
 more thoroughly standardized than those of Group 1. 
 
 One group of communities of less than 1000 stations each, un- 
 der one management, have been included in Group 3, and the re- 
 maining telephone exchanges investigated, in Group 4. 
 
 Consideration of the larger communities in which message-rate 
 service is provided, and in which much of the outside plant is 
 underground, has been omitted because of lack of data. There is, 
 however, no indication that this plan for rate determination cannot 
 be applied to such communities. 
 
 METHOD OF PLOTTING CURVES 
 
 The numbers of stations in the various exchanges were plotted 
 as abscissae on sheets of cross section paper against rates as 
 ordinates. The average curves were obtained by finding the center 
 of gravity of each group of points falling in a vertical column on 
 the curve sheets and on each sheet drawing a smooth curve through 
 as many as possible of these centers of gravity. 
 
 The points for the average-weighted-rate curves were ob- 
 tained by adding the products of the various rates and the corre- 
 sponding numbers of stations and dividing the sum of these products 
 by the total number of stations. The result is the same as would 
 be obtained by dividing the total operating income from local 
 service by the total number of stations. Many of the cases ex- 
 amined were checked in this manner. 
 
 Figures 2 to 7 show typical sets of residence-rate curves. One 
 hundred and twenty curves similar to these curves were plotted. 
 Those of Groups 1, 2, and 4 are summarized in Figures 8, 9, and 10. 
 Several of the less important curves were omitted from the sum- 
 mary-sheets for the sake of clearness. The curves of Group 3 are 
 not shown on a summary-sheet because they do not extend beyond 
 1000 stations, and because they coincide very closely with the lower 
 portions of the curves of Group 2, shown in Figure 9. 
 
 31 
 
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 32 
 

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 33 
 
FREE-SERVICE 
 
 It was found early in the investigation that free long-distance 
 service or "free-service" between communities has had an appre- 
 ciable effect upon the rates. This relation is to be expected because 
 the value of the service to each subscriber is increased by an increase 
 in the number of subscribers with whom he may, if he wishes, 
 obtain connection. 
 
 A sufficient number of exchange areas not affected by free- 
 service were available in the case of the communities of Group 4 
 to plot reliable curves of business-one-party, residence-one-party, 
 residence-rural, and average-weighted rates against numbers of 
 stations. Figures 2 and 3 show the residence-one-party curves. 
 
 The additional stations made available to the subscribers of a 
 community by means of free-service between communities cannot 
 be valued the same per station as the stations in the community 
 itself, because it is less convenient to use the facilities provided for 
 free-service than to use those provided for normal local service, 
 and because there is less community interest among subscribers in 
 neighboring communities than among those in the same commu- 
 nity. When the stations of Group 4 made available by free-service 
 facilities are discounted by a factor of .33 and the points corre- 
 sponding to the corrected exchange areas are plotted on sheets 
 containing the curves of Figures 2 and 3, as in Figures 4 and 5, it 
 will be seen that if curves representing the average of all of the 
 points — those which have been corrected for free-service, and those 
 which are not affected by free-service — were plotted, they would 
 not differ greatly from the curves of Figures 2 and 3. Greater or 
 less correction than that obtained by the use of the factor .33 will 
 result in curves which vary more or less from the original curves. 
 
 As the curves of Figures 2 and 3 are plotted with sufficient 
 points to be reliable, and as it may be assumed that the curves of 
 Figures 4 and 5 will have the same shapes if their one point of 
 difference — the effect of free-service — is properly weighted, .33 may 
 be accepted as the weighting-factor which properly indicates the 
 value of the free-service facilities with respect to the facilities pro- 
 vided for local service. 
 
 Data sheets were received from many telephone companies 
 which did not state whether or not free-service was provided. Al- 
 though it may reasonably be assumed that if no mention were made 
 of free-service, no free-service facilities were provided, the points 
 corresponding to these sheets were separated from the rest of the 
 points and plotted as in Figures 6 and 7 with the curves of Figures 
 2 and 3. It will be seen that their addition to the points of Figures 
 
 34 
 

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 35 
 
2 and 3 would not noticeably change the shape of the curves. Busi- 
 ness-one-party, residence-one-party, residence-rural, and average- 
 Weighted rates were treated in this manner. In the cases of busi- 
 ness-two and four-party, business-rural, and residence-two-party 
 rates, it was necessary in order to obtain enough points to give 
 reliable curves, to use the points corresponding to both exchange 
 areas with no free-service and exchange-areas with free-service, 
 with the necessary correction. It will be noted that the curve of 
 business-four-party rates bends below 1000 stations in a direction 
 opposite to that of the other curves. This curve is reliable in this 
 respect because the number of points in this region is large. The 
 corresponding curve for Group 1 of exchange-areas, plotted inde- 
 pendently, has the same shape. 
 
 In the case of residence-four-party rates it was found that the 
 curves did not correspond in shape to the other curves plotted. 
 This curve is one of slight slope, so that only a small correction 
 should be allowed for free-service in fixing rates. If too great 
 allowance for free-service has been made, no correction for free- 
 service, however great, which might be made, will make the points 
 fall on the average curves, because the correction for free-service 
 is made by moving the points horizontally along the axis of stations. 
 For this reason, it was decided that a misleading result would be 
 obtained if points corrected for free-service were used in plotting 
 the curve. These points were accordingly rejected and the curve 
 plotted from "no free-service" points and from points for which 
 no free-service conditions had been reported. In these cases it was 
 assumed, as stated above, that there was no free-service. 
 
 The numbers of points available with which to plot curves of 
 business-extension, residence-extension, and switching rates, and 
 private-branch-exchange-board, trunk and extension rates were 
 small so that points corrected for free-service as well as "no free- 
 service" points and those for which no free-service conditions had 
 been reported were used in obtaining the average curves. 
 
 The telephone service of the telephone companies of Group 1 
 provides generally for free-service so that points corrected for free- 
 service had to be used in plotting the curves of the various classes 
 of service. It is assumed that if the points were properly corrected 
 for free-service, the curves would have the shapes of the curves 
 obtained by plotting the "no free-service" points of Group 4. When 
 the business-one-party curve is plotted without correction for free- 
 service, and corrected by factors of .33 and .10, the latter curve is 
 similar in shape to the curve of "no free-service" points of Group 4, 
 while the curves plotted without correction and with a correction 
 
 36 
 
MONTHLY RATE (DOLLARS) 
 
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 37 
 
MONTHLY RATE (DOLLARS) 
 
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 38 
 
MONTHLY RATE (DOLLARS) 
 
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 39 
 
factor of .33 give curves which deviate in opposite directions from 
 the curves of Group 4. This result indicates that multiplying the 
 number of additional stations made accessible to a subscriber in any 
 community by free-service by a factor of .10 weights these stations 
 properly in comparison with the stations in the community itself. 
 In the case of the points of Group 4, the corresponding factor 
 was .33. 
 
 The method used in determining these factors does not make 
 it possible to obtain exact values or make sharp distinctions. How- 
 ever, the difference in factors indicates that, in fixing rates, greater 
 account has been taken of free-service in the cases of the telephone 
 companies of Group 4 than of Group 1. As a further check on this 
 factor for the companies of Group 1, the business-two-party points 
 were corrected for free-service with factors of .10 and .33, with a 
 like result. The curves of business-four-party, and rural rates, 
 residence-one, two- and four-party and rural rates, business, resi- 
 dence and private-branch-exchange extension rates, private-branch- 
 exchange-board and trunk rates, and average-weighted rates were 
 plotted, with a correction factor of .10. Similarly, a correction fac- 
 tor of .10 was found to be the most satisfactory one for the curves 
 of Group 2. 
 
 The values of the correction factors for these groups of com- 
 munities indicate that less importance has been attached to free- 
 service by the more highly developed telephone companies than by 
 the smaller ones. More skillful consideration of the relative values 
 of the various elements of service has brought a realization of the 
 over-emphasis which has been placed upon free-service by the tele- 
 phone companies and the public-utility commissions. The develop- 
 ment of other phases of the service has placed free-service in a 
 relatively less important position. 
 
 Free-service works an injustice to many of the local exchange 
 subscribers. The cost of maintaining free-service between commu- 
 nities which is in reality used by a small proportion of the local 
 exchange subscribers, must be distributed over the local exchange 
 rates so that the telephone rates of all telephone subscribers in a 
 community are higher in order that a few subscribers may have 
 the benefit of a special kind of telephone service. 
 
 INCREASE IN TELEPHONE RATES WITH SIZE OF COMMUNITIES 
 The rates for telephone service in all cases increase rapidly 
 with the number of stations for the small communities and less 
 rapidly for the large ones. There are two important reasons for- 
 this increase: First, the increase in the cost of the necessary tele- 
 phone plant, and the cost of operating it per station for a given 
 
 40 
 
grade of telephone service increase with the numbex of stations 
 served. Second, — a point which is frequently not realized by tele- 
 phone subscribers — ^the quality of service demanded is higher and 
 the use made of it iper station is greater in the large communities. 
 The people in the large communities have become more accustomed 
 to telephone service and more dependent upon it than those in the 
 small communities. 
 
 This increased cost of telephone service in the large commu- 
 nities is accompanied by an increased value to the subscriber, be- 
 cause of the possibility of obtaining connection with a greater 
 number of other persons in the community. This increased value 
 of the telephone service to the subscriber is not the reason for the 
 higher telephone rates in the large communities, but it has been 
 referred to so frequently that there is a large proportion of the 
 telephone-using public who think that the telephone companies 
 have made the increased value an excuse for higher telephone rates. 
 
 Let us consider two communities having telephone companies 
 which operate respectively 20,000 and 40,000 stations. If the aver- 
 age calling-rate per station during the busy-hour were .55, 11,000 
 calls would be initiated during the busy-hour in the first telephone 
 exchange. A higher average calling-rate per line may be assumed 
 for the second exchange, because the service is more valuable to 
 each subscriber. If the average calling-rate were .65, 26,000 calls 
 would be initiated during the busy-hour, or a considerably greater 
 number of calls per subscriber. The Increase in operating force 
 needed in the larger exchange over the smaller one would be in 
 still greater proportion because the average call would consume 
 more operators' time. A larger proportion of calls would be 
 trunked from one central office to another, and a greater length of 
 time would be consumed in completing trunked calls than those calls 
 in which both the called and calling subscribers are connected in 
 the same central office. The cost of operating the switchboards 
 per station would, therefore, be greater in the larger exchange. 
 
 The cost of the switchboard per station would be greater in the 
 exchange of 40,000 lines because of the increased switchboard space 
 necessary to accommodate the greater number of operators, and 
 because of the greater complexity of equipment. 
 
 Not only will the cost of central-office building and land be 
 greater because of the greater space required, but also because of 
 the higher real-estate values in the larger communities. Some of 
 the fixed charges, such as taxes, are much higher proportionally 
 in the larger communities. 
 
 The outside-plant cost per station is higher in the city than the 
 Siftall town, because of the high cost of underground construction, 
 
 41 
 
and the delicate construction problems made necessary by the con- 
 gestion of aerial equipment in the streets, and consequent high cost 
 of such construction. In many cases also the average distance from 
 the subscribers' station to the central office is greater, and the plant 
 cost per station is greater for this reason. 
 
 The investment cost per station of the large telephone system 
 would thus be greater than that for the small system, and mainte- 
 nance and other operating and fixed costs also increase rapidly with 
 the size of the community. If a merger of two competing telephone 
 companies in a city, each operating 20,000 stations, had been ef- 
 fected, the same increase in investment and operating cost would 
 have resulted, but the elimination of duplication of "stations would 
 to some extent, though probably only slightly, compensate for the 
 increased costs mentioned above. 
 
 COMMENTS ON STATION-RATE CURVES 
 
 In order to check the relative reliability of the curves it was 
 noted what percentages of points fell within and without given 
 bands on each side of the curves. In the curves of Group 4, the 
 residence curves are apparently better established than the business 
 curves ; also the business curves of Groups 1 and 2 showed greater 
 reliability than the business curves of Group 4. 
 
 While an exact proportionality in variation among the curves 
 on each curve sheet cannot be expected, still it may be seen by an 
 inspection of Figures 8, 9, and 10 that they are approximately pro- 
 portional, so that, for a given variation in the average-weighted- 
 rate curves, a proportional variation in the remaining curves may 
 be assumed without serious error. 
 
 The curves of Groups 1, 2, 3, and 4 have the same general shape, 
 but those of Groups 1, 2, and 3 indicate higher rates than those of 
 Group 4, as would be expected from the higher grade of service. 
 
 The average-weighted-rate curves of Groups 1, 2, and 3 have 
 greater slopes than that of Group 4 because they are affected to a 
 greater extent in Groups 1, 2, and 3 by the steep-sloping business- 
 rate curves than is the average-weighted-rate curve of Group 4. 
 
 The more rapid rise in the lower portions of the curves of 
 Groups 2 and 3, and the higher rates are probably accounted for by 
 the more aggressive managements of Groups 2 and 3. 
 
 In Groups 1, 2, and 4 it may be noticed that the station-rate 
 curve for private-branch-exchange trunks exceeds the business- 
 party curve by an approximately constant difference. This differ- 
 ence would be expected since the first private-branch-exchange 
 trunk installed usually includes one private-branch-exchange 
 switchboard. : In Group 3, the rate for private-branch-exchange 
 
 42 
 
trunks is quoted as the business-party rate plus the rental of one 
 switchboard. The constant difference, then, probably represents 
 the rental of a private-branch-exchange switchboard. 
 
 In all groups, the rate for extension service is practically inde- 
 pendent of stations as shown by the station-rate curves. An ex- 
 tension makes the telephone more accessible to the subscriber but 
 does not necessarily greatly increase his use of the telephone. The 
 cost to the company is merely the rental of the subset and asso- 
 ciated equipment plus a small cost of operation and maintenance 
 regardless of the size of the exchange. 
 
 NORMAL-COST BASIS OF STATION-RATE CURVES 
 There has been much discussion of the relative merits of "origi- 
 nal cost," "reproduction cost," and other costs as a fair and prac- 
 ticable rate-base. "Normal cost" has of late been considered with 
 favor by many public-utility commissions, because it is based upon 
 average costs over a number of years, and eliminates abnormal 
 costs which would make the rate base abnormally high or low. It 
 has a disadvantage, however, of making the determination of the 
 rate-base more dependent upon the soundness of the judgment of 
 the appraiser than the other "costs." 
 
 The rates of the station-rate curves are based upon normal 
 costs. In any one group of communities having the same number 
 of stations, some of the telephone systems will have been con- 
 structed in times of high cost, and others in times of low cost. The 
 rates in each community resulting from the bargaining between the 
 telephone company and the subscribers will tend towards those 
 which include costs of operation and maintenance plus a return on 
 the actual investment, whether this investment was made in time 
 of high or of low prices. The average rates for these communities, 
 or the rates shown by the station-rate curves, therefore, include 
 average costs of operation and maintenance of all of the com- 
 panies in a group, plus a return upon the average of investment 
 costs of the telephone systems over a number of years, or the 
 normal cost. 
 
 DEPENDENCE OF RELIABILITY OF STATION-RATE CURVES UPON 
 
 FREE COMPETITION 
 The fairness of the station-rate curves as a basis from which 
 to determine rates for individual telephone companies depends upon 
 freedom of bargaining in the various communities between tele- 
 phone companies and subscribers. When the rates are arbitrarily 
 determined by rate specialists and not by free bargaining, the aver- 
 age rates are not necessarily fair ones from which to determine the 
 rates for individual communities. 
 
 43 
 
SECTION VII. EVALUATION OF BONUSES AND PENALTIES 
 WHICH HAVE BEEN APPLIED 
 
 BONUS AND PENALTY BASES 
 It is assumed in this report that the bases upon which bonuses 
 and penalties should be granted are (a) miles of pole line per sta- 
 tion, (b) maximum busy-hour calling-rate, (c) average calls per 
 day per station, and (d) development. It is assumed further that 
 these bonus and penalty bases are so fundamental that they have 
 been recognized and taken into account by public-utility commis- 
 sions, telephone companies, and the telephone-using public, so that 
 if their values are averaged in a sufficient number of cases in a 
 sufficient number of states of the same general character, values 
 will be obtained which are a measure of what has been the average 
 judgments of those organizations and of those people interested 
 in the determination of telephone rates. In this investigation bonus 
 and penalty bases (b) and (c) are combined into one cost and value 
 bonus and penalty base. The value obtained for this base will be 
 the sum of those which would be obtained if separate bases were 
 assumed. Other bonuses and penalties, as for example, one for 
 plant condition, may be added if desirable, without changing the 
 methods of evaluation. The actual inconvenience and labor of 
 the evaluation will, however, increase with the number of bonus 
 and penalty bases assumed. 
 
 THE RATE DEVIATION EQUATION 
 It is assumed that a deviation from the average for a telephone 
 rate is accounted for by deviation from the average of miles of pole 
 line per station, average calls per day per station, and development, 
 
 ^^ KP -t- KC + KD = R, 
 
 which we may call a rate deviation equation, where 
 
 P = percentage deviation from the average miles of pole line 
 
 per station. 
 C = percentage deviation from the mean of the average calls 
 
 per day per station. 
 D = percentage deviation from the average development. 
 R = percentage deviation from the mean of the average- 
 weighted rate for an exchange of the size in question. 
 K = percentage bonus or penalty per percent of deviation from 
 
 average miles of pole line per station. 
 K2 = percentage bonus or penalty per percent of deviation from 
 
 the mean of the average calls per day per station. 
 Ks = percentage bonus or penalty per percent of deviation from 
 average development. 
 44 
 
LIMITATIONS ON SCOPE AND EXACTNESS OF EVALUATION OF 
 BONUSES AND PENALTIES 
 
 It cannot be assumed that the constants should be the same for 
 exchanges of all sizes, so that the exchanges from which any set of 
 constants is evaluated should all be of approximately the same size. 
 In this report, only those exchanges operating from one thousand 
 to three thousand stations were considered. If it were possible to 
 obtain the necessary information in regard to a sufficient number 
 of exchanges, including a smaller range of stations, the results 
 would be more reliable. 
 
 In the evaluation of bonuses and penalties which have been 
 applied by various public-utility commissions and telephone com- 
 panies, no account has been taken of free-service except in so far 
 as it has changed development. 
 
 It would be desirable to correct rates in cases where increased 
 rates have been granted because of free-service, and, in the forma- 
 tion of the equations for solution, to omit in the development factors 
 the correction for free-service. As information with which to make 
 the correction for rates was not available, the equations for those 
 exchanges in which free-service was appreciable were omitted. 
 There is no reason to suppose that the error, resulting from the 
 inclusion of the equations for exchanges in which the amount of 
 free-service given is small, is serious. 
 
 Because of the difficulty of explaining what information was 
 desired, and because the records examined were not intended 
 to give this information, the information in regard to the bases 
 for bonuses and penalties of many of the cases were insufficient 
 or unreliable ; hence these cases had to be rejected. 
 
 POSSIBLE METHODS OF EVALUATING BONUSES AND PENALTIES 
 Several methods may be followed in evaluating the constants 
 K, K2, and K.. They are as follows : 
 
 (1) Write the equations for the various individual cases 
 using the unknown constants K, K., and Ks for each case, but 
 for each individual case using its own numerical values for P, 
 C, D, and R. Solve algebraically for the unknown constants, 
 Ki, Ki, and Ks, for each possible combination of three equations, 
 and average the values of K, JL, and K obtained. This method 
 is laborious and its reliability is doubtful. 
 
 (2) Write the equations for the various individual cases 
 as for (1) . Then separate them into three equal groups, those 
 with large positive rate deviations, R, in one group, those with 
 large negative rate deviations in another group, and those with 
 
 46 
 
zero and small positive and negative rate deviations in the third 
 group. Obtain averages of miles of pole line per station, aver- 
 age calls per day per station, development, and rate deviations 
 in each group without changing the signs of the negative de- 
 viations. With the three sets of average values, and K, K, 
 and Ks, write three deviation equations, and solve for Ki, HL, 
 and Ks. While this method is not laborious, it was not used in 
 this report because the number of cases, small at the start, had 
 to be separated into three groups, and average deviations ob- 
 tained for each group. This would render the results unreli- 
 able. If a large number of cases is available, the results ob- 
 tained by this method should be reasonably reliable. 
 
 (3) Write the equations for the various individual cases 
 as for (1). Then find the most probable values of Ki, K, and 
 Ka, and the probable errors in each case, by means of the Method 
 of Least Squares. The details of applying this method to the 
 solution of a group of independent observations of equal weight 
 such as those in Table 5 may be obtained from many sources, 
 among which may be mentioned Chapters 3, 4, and 10 of 
 "Method of Least Squares" by Mansfield Merriman. This is the 
 method of solution which was used in this investigation. It is 
 the most satisfactory method because it depends upon no 
 doubtful assumptions. By it may be determined not only the 
 most probable values of Ki, Ks, and Ka, but also the probable 
 errors in each case. The probable error in any case is such 
 that the number of errors greater than it equals the number 
 which are smaller than it. This method of solution thus gives 
 a definite measure of the reliability of the values of K, Ks, and 
 Ks obtained. 
 
 SOURCES OF INFORMATION 
 
 Tables 2, 8, and 4 show the method of deriving from funda- 
 mental data the percentages of deviation from the average. Table 
 2 shows the data and deviations for thirty-five exchanges in Ohio. 
 This information was obtained from records of the Public Utility 
 Commission of Ohio and the Bulletin on "Population of Ohio" of 
 the "Fourteenth Census of the United States." The population 
 of the territory served by the exchange, or the "exchange-area," 
 was calculated by assuming that the populations of the "exchange- 
 city," and the whole "exchange-area" are to each other as the sta- 
 tions in the exchange-city and the total stations. 
 
 Table 3 shows the data and deviations for forty-four exchanges 
 in Ohio, Indiana, Illinois, Wisconsin, and Iowa. These data were 
 obtained from "Memorandum Concerning Telephone Companies and 
 
 46 
 
Telegraph Companies Reporting to the Interstate Commerce Com- 
 mission for 1917," and bulletins on populations of the states under 
 consideration of the "Fourteenth Census of the United States." 
 It was necessary in this case, because of lack of information in re- 
 gard to division of stations between the exchange-city and its sur- 
 rounding exchange-area, to use total stations and population of the 
 city or town in obtaining development. There is very little error 
 in the development obtained by this method for cities, but consid- 
 erable error in the cases of small towns and villages. 
 
 Table 4 shows the data and deviations for twenty-three of the 
 exchanges considered in Table 3. Letters were written to all of 
 the exchanges in Table 3, requesting accurate information. Inci- 
 dentally, this information aflforded a means of checking the accuracy 
 of the populations of the exchange-areas as obtained for Table 2. 
 Estimates of population of the exchange-areas were requested, and 
 the deviations based upon these estimates agree fairly well with 
 those calculated by the method of Table 2. 
 
 In Table 5 are collected the values of P, C, D, and R of selected 
 cases of Tables 2, 3, and 4 and some additional ones received in 
 answer to the letters to Middle Western telephone companies, re- 
 ferred to in the discussion of Table 4. These selected cases were 
 used in the solution by the Method of Least Squares. Only those 
 cases were included in this table which were free from any apparent 
 possibility of error. 
 
 BONUSES AND PENALTIES WHICH HAVE BEEN APPLIED 
 The solution of the deviation equations gives the following 
 probable values of the constant with the corresponding probable 
 errors : 
 
 K = .08± .6 
 K = .16± .8 
 Ks = .02 + 1.3 
 
 That is, for a one percent variation in miles of pole line per 
 station a bonus or penalty of eight hundredths of one percent has 
 been applied to the rate, and the probable error of this observation 
 is plus or minus six-tenths of one percent or nearly eight times the 
 probable value of K. The values of K and K may be interpreted 
 similarly. The bonuses or penalties based upon P, C, and D which 
 have unconsciously been applied have been small, and in the case 
 of D, development, negligible. Development has apparently re- 
 ceived little or no recognition as a proper basis for a bonus or 
 penalty. 
 
 47 
 
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 51 
 
TABLE 5 
 DEVIATIONS USED IN OBTAINING CONSTANTS 
 Values of the percentages of deviation, P, C, D, and R, from the observa- 
 tion equations of the form, Ki P+K^ C+Kj D:^R, applying to the consistent 
 cases chosen for solution by Method of Least Squares. 
 
 1 
 
 No. of 
 Case 
 
 1 
 
 1 
 P 
 
 C 
 
 D 
 
 B 
 
 No. of 
 Case 
 
 P 
 
 c 
 
 D 
 
 B 
 
 1 
 
 —47 
 
 + 3 
 
 + 18 
 
 — 6 
 
 36 
 
 +77 
 
 +129 
 
 +10 
 
 +32 
 
 2 
 
 —21 
 
 +93 
 
 — 4 
 —18 
 
 — 1 
 
 37 
 
 + 3 
 
 + 2 
 
 +27 
 
 + 8 
 
 3 
 
 +20 
 
 —16 
 
 — 7 
 
 38 
 
 —63 
 
 +116 
 
 — 4 
 
 + 8 
 
 4 
 
 —37 
 
 -19 
 
 — 6 
 
 — 1 
 
 39 
 
 —31 
 
 —17 
 
 + 12 
 
 + 6 
 
 5 
 
 —25 
 
 —26 
 
 —30 
 
 — 7 
 
 40 
 
 — 1 
 
 —20 
 
 — 4 
 
 — 5 
 
 6 
 
 —28 
 
 —68 
 
 + 12 
 
 —24 
 
 41 
 
 —29 
 
 —20 
 
 — 1 
 
 — 6 
 
 7 
 
 +26 
 
 — 7 
 
 —25 
 
 + 19 
 
 42 
 
 —31 
 
 +61 
 
 —36 
 
 +12 
 
 8 
 
 —24 
 
 + 15 
 
 + 10 
 
 — 4 
 
 43 
 
 +20 
 
 — 2 
 
 — 6 
 
 + 2 
 
 9 
 
 —65 
 
 —11 
 
 —27 
 
 —16 
 
 44 
 
 +86 
 
 —33 
 
 +37 
 
 +12 
 
 10 
 
 -71 
 
 —65 
 
 + 6 
 
 + 3 
 
 45 
 
 —61 
 
 + 18 
 
 —32 
 
 — 5 
 
 11 
 
 —11 
 
 —27 
 
 + 21 
 
 — 6 
 
 46 
 
 +38 
 
 ■+ 7 
 
 + 3 
 
 + 
 
 12 
 
 + 17 
 
 + 7 
 
 + 1 
 
 + 3 
 
 47 
 
 +40 
 
 +110 
 
 + 8 
 
 +20 
 
 13 
 
 —48 
 
 — 3 
 
 +62 
 
 — 9 
 
 48 
 
 +62 
 
 —61 
 
 +17 
 
 —12 
 
 14 
 
 +117 
 
 —20 
 
 — 8 
 
 + 14 
 
 49 
 
 -21 
 
 +30 
 
 — 1 
 
 —18 
 
 16 
 
 + 64 
 
 — 9 
 
 —22 
 
 +21 
 
 60 
 
 —45 
 
 —46 
 
 —24 
 
 —12 
 
 16 
 
 —49 
 
 +57 
 
 —12 
 
 + 8 
 
 61 
 
 +20 
 
 —12 
 
 — 4 
 
 +18 
 
 17 
 
 +56 
 
 — 4 
 
 —24 
 
 +34 
 
 62 
 
 +37 
 
 —35 
 
 +62 
 
 —17 
 
 18 
 
 -3 
 
 —44 
 
 +23 
 
 — 8 
 
 53 
 
 48 
 
 + 9 
 
 +40 
 
 — 2 
 
 19 
 
 +72 
 
 + 4 
 
 —18 
 
 + 3 
 
 54 
 
 +59 
 
 -31 
 
 + 6 
 
 —24 
 
 20 
 
 —19 
 
 — 2 
 
 +28 
 
 +12 
 
 56 
 
 —62 
 
 + 2 
 
 -4 
 
 + 1 
 
 21 
 
 —49 
 
 —10 
 
 +32 
 
 + 9 
 
 56 
 
 +128 
 
 —36 
 
 —22 
 
 —24 
 
 22 
 
 —46 
 
 +28 
 
 —18 
 
 +21 
 
 67 
 
 —72 
 
 —40 
 
 —46 
 
 —15 
 
 23 
 
 +17 
 
 —20 
 
 +21 
 
 +14 
 
 68 
 
 1 —86 
 
 + ^ 
 
 —129 
 
 —15 
 
 24 
 
 + 3 
 
 + 4 
 
 —26 
 
 +23 
 
 69 
 
 1 -21 
 
 +28 
 
 — 3 
 
 — 1 
 
 26 
 
 +28 
 
 +21 
 
 —30 
 
 +11 
 
 60 
 
 1 +21 
 
 1 —16 
 
 —30 
 
 — 4 
 
 26 
 
 I + 
 
 -14 
 
 +30 
 
 —10 
 
 61 
 
 —46 
 
 +37 
 
 —16 
 
 +22 
 
 27 
 
 —69 
 
 —29 
 
 + 7 
 
 —26 
 
 62 
 
 1 +19 
 
 —12 
 
 —10 
 
 — 6 
 
 28 
 
 +54 
 
 —39 
 
 + 9 
 
 — 7 
 
 63 
 
 -67 
 
 +34 
 
 + 9 
 
 +25 
 
 29 
 
 1 —46 
 
 -14 
 
 + 
 
 —11 
 
 64 
 
 1 —72 
 
 —24 
 
 + 7 
 
 —14 
 
 30 
 
 —24 
 
 +23 
 
 — 2 
 
 + 2 
 
 66 
 
 +260 
 
 +21 
 
 +22 
 
 +37 
 
 31 
 
 —34 
 
 —24 
 
 +12 
 
 — 2 
 
 66 
 
 1 +16 
 
 1 -6 
 
 — 6 
 
 — 6 
 
 32 
 
 —20 
 
 —87 
 
 +80 
 
 —21 
 
 67 
 
 
 1 -13 
 
 —10 
 
 — 8 
 
 33 
 
 —20 
 
 + 134 
 
 — 9 
 
 +11 
 
 68 
 
 1 +23 
 
 —20 
 
 + 9 
 
 — 2 
 
 34 
 
 —57 
 
 +35 
 
 + 2 
 
 + 8 
 
 69 
 
 1 —57 
 
 +24 
 
 — 6 
 
 + 6 
 
 35 
 
 +24 
 
 —60 
 
 +81 
 
 +30 
 
 
 1 
 
 1 
 
 
 
 Ki = .08±,6 
 
 K. 
 
 .16+,. 
 62 
 
 K. = .02+.1.3 
 
The high degree of uncertainty in the values of these constants 
 is due to the fact that if bonuses or penalties P, C, or D were applied, 
 it was done unconsciously and, therefore, in an irregular and un- 
 certain manner. The injustice of the present system of rate de- 
 termination, which has, in many cases, penalized some telephone 
 companies for the same conditions for which it has rewarded others, 
 is strongly indicated by these results. 
 
 SECTION VIII. APPROXIMATELY JUST BONUSES AND 
 
 PENALTIES 
 The values of the bonus and penalty constants which should 
 justly be applied may be approximately computed as follows: As- 
 sume a division of plant valuation as shown in Table 6, which is a 
 reasonable average estimate for telephone plants of the size con- 
 sidered — one thousand to three thousand stations — and average 
 percentages which the elements of production and investment ex- 
 penses are of plant valuation, as shown in Table 7. Then analyze 
 the effects on rates of variations in miles of pole line per station, 
 average calls per day per station, and development. Such analyses 
 will indicate that the constants should have larger values than those 
 obtained above. TABLE 6 
 
 DIVISION OF TELEPHONE PLANT VALUATION 
 
 Percentage of Total 
 Division of Telephone Plant Plant Valuation 
 
 Outside plant 60 
 
 Substation equipment 20 
 
 Central o&de equipment 10 
 
 Miscellaneous equipment 10 
 
 Total 100 
 
 TABLE 7 
 TELEPHONE PRODUCTION AND INVESTMENT COSTS 
 
 Division of Cost Percentage of Plant 
 
 Production Costs: Valuation 
 
 Traffic 8.0 
 
 Maintenance 4.5 
 
 Commercial 2.5 
 
 General 1.5 
 
 Investment Costs: 
 
 Taxes 1.5 
 
 Insurance 5 
 
 Depreciation 7.5 
 
 Interest 8.0 
 
 Total Costs 34.0 
 
 EFFECT OF INCREASING MILES OF POLE LINE PER STATION 
 If it is assumed that "A" is the original plant valuation, and 
 that the miles of pole line per station are increased one hundred 
 
 63 
 
percent, the average calls per station and development remaining 
 unchanged, the original and increased costs of operation are as 
 follows: ^^gLE 8 
 
 EFFECT OF INCREASING MILES OF POLE LINE PER STATION 
 
 Production Costs: 
 
 Original Cost 
 of Operation 
 
 Increased Coat 
 of Operation 
 
 Traffic (8 percent) 
 
 .08 X A 
 
 (.08 xA) 
 
 Maintenance (4.5 percent) 
 
 .045 X A 
 
 (.045 X A) + (.0166 X .6 X A) 
 
 Commercial (2.5 percent) 
 
 .025 X A 
 
 (.025 X A) 
 
 General (1.5 percent) 
 
 .015 X A 
 
 (.015 X A) 
 
 Investment Costs: 
 
 
 
 Taxes (1.5 percent 
 
 .015 X A 
 
 (.015 X A) + (.015 X .6 X A) 
 
 Insurance (.5 percent) 
 
 .005 X A 
 
 (.005 X A) + (.005 X .6 X A) 
 
 Depreciation (7.5 percent) 
 
 .075 X A 
 
 (.075 X A) + (.075 X .6 X A) 
 
 Interest (8 percent) 
 
 .08 XA 
 
 (.08 X A) + (.08 X .6 X A) 
 
 Total Cost (34 percent) 
 
 .34 X A 
 
 (.34 X A) + (.115 X A) 
 
 Percent increase = 100 0^\= 33.8 
 
 It is assumed that maintenance increases but not in proportion 
 to increased length of pole line. An increased cost of operation 
 of 33.8 percent for the above one hundred percent increase or .338 
 percent per percent increase in miles of pole line per station results. 
 Miles of pole line per station is entirely a cost bonus-and-penalty 
 base. Therefore, the bonus-and-penalty constant should be of the 
 order of magnitude of .34 instead of .08, the constant at present 
 applied. 
 
 EFFECT OF INCREASING AVERAGE CALLS PER DAY PER STATION 
 If the average calls per station are increased one hundred per- 
 cent, the miles of pole line per station, and development remaining 
 unchanged, the cost of operation increases as follows : 
 
 TABLE 9 
 EFFECT OP INCREASING AVERAGE CALLS PER DAY PER STATION 
 
 PrnHiiptinn r,n<5t«- Original Cost Increased Cost 
 
 rroauction UOStS. of Operation of Operation 
 
 Traffic (8 percent) .08 X A (.08 X A) -|- (.08 X A) 
 
 Maintenance (4.5 percent) .045 X A (.045 X A) -|- (.045 X .1 X A) 
 
 Commercial (2.5 percent) .025 X A (.025 X A) 
 
 General (1.5 percent) .015 X A (.015 X A) 
 Investment Costs: 
 
 Taxes (1.5 percent) .015 X A (.015 X A) + (.015 X .1 X A) 
 
 Insurance (.5 percent) .005 X A (.005 X A) -f (.005 X .1 X A) 
 
 Depreciation (7.5 percent) .075 X A (.075 X A) + (.075 X .1 X A) 
 
 Interest (8 percent) .08 X A (.08 X A) -)- (.08 X .1 X A) 
 
 Total Cost (34 percent) .34 x A (.34 X A) + (.102 X A) 
 
 Percent increase = 100 I' . I=:30 
 
 The increase in the cost of operation for the one hundred per- 
 cent increase in average calls per station per day is 30.0 percent or 
 .30 percent per percent increase in average calls per station per day. 
 
 64 
 
Original Cost 
 
 Increased Cost 
 
 of Operation 
 
 of Operation 
 
 .08 X A 
 
 (.08 X A) + (.08 X A) 
 
 .045 X A 
 
 (.045 X A) + (.045 X A) 
 
 .025 X A 
 
 (.025 X A) + (.025 X A) 
 
 .015 X A 
 
 (.015 X A) + (.015 X A) 
 
 .015 X A 
 
 (.015 X A) + (.015 X A) 
 
 .005 X A 
 
 (.005 X A) + (.005 X A) 
 
 .075 X A 
 
 (.075 X A) + (.075 X A) 
 
 .08 XA 
 
 (.08 X A) + (.08 X A) 
 
 .34 X A 
 
 (.34 X A) + (.34 X A) 
 
 As each subscriber uses his telephone twice as much as he did 
 originally, it may reasonably be assumed that the value of the 
 service has been increased 100 percent or one percent per percent 
 increase in calls per station. If the value of the bonus and penalty 
 base is the average of the above percentages, it should be .65 in- 
 stead of .16, the constant at present applied. 
 
 EFFECT OF INCREASING DEVELOPMENT 
 If the development were increased one hundred percent, the 
 miles of pole line per station, and the average calls per day per 
 station remaining unchanged, the cost of operation would increase 
 as follows : TABLE 10 
 
 EFFECT OP INCREASING DEVELOPMENT 
 Production Costs: 
 
 Traffic (8 percent) 
 Maintenance (4.5 percent) 
 Commercial (2.5 percent) 
 General (1.5 percent) 
 Investment Costs: 
 
 Taxes (1.5 percent 
 Insurance (.5 percent) 
 Depreciation (7.5 percent) 
 Interest (8 percent) 
 
 Total Cost (34 percent) 
 
 Percent increase = 100 ( W )= 1^0 
 
 The increase in cost of operation is one hundred percent, but as 
 there is also an increase of one hundred percent in the number of 
 stations, there is no increase in the cost of operation per station. 
 However, each subscriber has access to twice as many other sub- 
 scribers as originally, so that as a first approximation the value 
 of the service to each subscriber may be assumed to have increased 
 one hundred percent. If the bonus and penalty base is the average 
 of the percentages of increase of cost and value, it should be .50 
 instead of .02, the constant at present applied. 
 
 SECTION IX. JUST BONUSES AND PENALTIES 
 The above method of computing the proposed bonus and pen- 
 alty constants is such an approximate one that they cannot be 
 accepted without a further analysis of their effects upon a telephone 
 company, which attempts to obtain a bonus by increasing P, C, or 
 D, and upon its subscribers. In order to make such an analysis, a 
 suggested classification of telephone companies in accordance with 
 rates will be made, a typical telephone exchange chosen, and an 
 analysis made of the effect of increasing P, C, and D, separately, 
 the other two constants remaining unchanged in each case. 
 
 65 
 
Throughout this discussion, non-essential digits and fractions will 
 be omitted. 
 
 CLASSIFICATION OP TELEPHONE EXCHANGES IN ACCORDANCE 
 WITH RATES AND NUMBERS OF STATIONS OPERATED 
 
 In classifying the telephone exchanges with respect to rates, 
 the most practicable plan will be to define arbitrarily the classes of 
 telephone exchanges with respect to the numbers of stations oper- 
 ated, and to make a separate rate schedule for each class. As the 
 smallest change in rate which is ordinarily considered is 25 cents 
 a month, and as the business-one-party station-rate curve has the 
 greatest slope and the greatest reliability of the station-rate curves, 
 the basis for classification used is a change of 25 cents a month on 
 the business-one-party curve. By a comparision of the slopes of the 
 business-one-party and average-weighted-rate curves, between 1000 
 and 3000 stations, it will be seen that the ratio of slopes is approxi- 
 mately 5 to 1 ; that is, a change of 25 cents a month on the business- 
 one-party curve corresponds to a change of approximately 5 cents 
 a month on the average-weighted-rate curve. 
 
 Marking off 25-cent intervals from $2.00 to $6.00 on the busi- 
 ness-one-party curve of Group 4, seventeen classes are obtained as 
 shown in Table 11. The corresponding numbers of stations may be 
 obtained by drawing vertical lines from the points on the curve to 
 
 the axis of stations. ^ * t>t -ni i , 
 
 TABLE 11 
 
 STATION-RATE CLASSIFICATION 
 
 Business- Corre- 
 
 Rate One-Party spending Limits in Station Limits in 
 
 Class Rate Stations Stations Class Stations 
 
 1 $2.00 1-100 
 
 2 2.25 220 101-300 A 1-700 
 
 3 2.50 500 301-700 
 
 4 2.75 1000 701-1300 B 301-1800 
 
 5 3.00 1550 1301-1800 
 
 6 3.25 2200 1801-2600 C 701-3400 
 
 7 3.50 3000 2601-3400 
 
 8 3.75 3800 3401-4200 
 
 9 4.00 4600 4201-5000 D 1801-7400 
 
 10 4.25 5400 5001-5800 
 
 11 4.50 6200 5801-6600 
 
 12 4.75 7000 6601-7400 E 3401-9900 
 
 13 6.00 7850 7401-8200 
 
 14 5.25 8700 8201-9100 
 
 15 5.50 9500 9101-9900 F 7401-11700 
 
 16 5.75 10350 9901-10700 
 
 17 6.00 11200 10701-11700 
 
 The second and third columns show the rates and corresponding 
 numbers of stations for the rate classes. The fourth column shows 
 the numbers of stations limiting the rate classes. The station-class 
 
 56 
 
limits, in the sixth column, are chosen so that each exchange will be 
 placed in two classes. To the classification of business-one-party 
 rates correspond similar classifications of all of the other rates. 
 
 It will probably not be desirable that the telephone companies 
 adhere rigidly to these classifications. The income of each exchange 
 will be determined by the average weighted rate of the rate-class 
 in which the exchange is placed, modified by bonuses or penalties 
 which may be applied to it. 
 
 The telephone companies can generally be depended upon to 
 allocate their rates so that the service will be developed in the man- 
 ner most satisfactory to the community, for this will generally be 
 the allocation which will be most profitable to the telephone com- 
 pany. If cases occur where the telephone company, having been 
 assigned an average-weighted rate and bonuses or penalties, at- 
 tempts by manipulating its rate classification to increase its income 
 at the expense of the community, it will be made apparent to the 
 public-utility commission by comparison with the average rate 
 classifications of all exchanges. The telephone company may then 
 be given an opportunity to justify its classification. Cases will, of 
 course, occur where abnormal rate-classifications are justified, but 
 they should always be subjected to examination. 
 
 Each telephone exchange shall be assigned to two station- 
 classes. By the application of bonuses, a telephone company might 
 possibly obtain the highest rate in the upper class, or by the appli- 
 cation of penalties, it may have to accept the lowest rate in the lower 
 class. Thus, an exchange operating 1500 stations would be placed 
 in Classes B and C. It might be able by bonuses to obtain a rate 
 of $3.50 a month for business-one-party service, or it might have 
 to accept $2.50 a month because of penalties. The correction by 
 bonuses or penalties shall be made from the rate of the non-over- 
 lapping, or rate classes. Thus the bonuses and penalties of the 
 exchange of 1500 stations would be applied to a rate of $3.00 a 
 month. If sufficient bonus were applied to amount to 25 cents a 
 month, the rate schedule corresponding to $3.25 a month would 
 apply. The above classification will amply provide for bonuses or 
 penalties which are likely to be earned by abnormal bonus and 
 penalty bases. 
 
 THE TYPICAL TELEPHONE EXCHANGE 
 In order to obtain further information in regard to the fairness 
 of the present and proposed bonuses and penalties, they were ap- 
 plied to a typical exchange of 2000 stations, which is an average 
 of the range of numbers of stations in the exchanges to which the 
 present constants apply. Since all of the data from which the 
 
 B7 
 
present bonus and penalty constants were obtained refer to the 
 exchanges of Group 4, the station-rate curves of this group were 
 used in assigning limits to the various classes. Referring to Table 
 11, it may be seen that the typical exchange of 2000 stations may 
 fall in station-classes C or D. 
 
 Making use of the average values which apply to the Ohio 
 telephone exchanges of Table 2, the plant and service statistics 
 of Table 12 would apply to the typical telephone exchange of 2000 
 stations. TABLE 12 
 
 STATISTICS OF TYPICAL TELEPHONE EXCHANGE OF 
 TWO THOUSAND STATIONS 
 
 1. Working stations 2,000 
 
 2. Miles of pole line (2000 x .075) 150 
 
 3. Average calls per day (2000 x 5.02) 10,040 
 
 4. Maximum busy-hour load (2000 x .710) 1,420 
 
 5. Population of field for development (2000/229) (1000) 8,750 
 
 6. Plant valuation (44880/0.34) $132,000 
 
 7. Gross annual income (2000 x 1.87 x 12) $44,880 
 
 8. Kate for business-one-party service (Class 6) $3.25 
 
 RATE AND BONUS AND PENALTY CHANGES REQUIRED TO RAISE 
 AN EXCHANGE FROM ONE RATE CLASS TO ANOTHER 
 
 As has been pointed out, a change of 5 cents a month on the 
 average-weighted-rate station-rate curve corresponds to a change 
 of 25 cents a month on the business-one-party curve. Then from 
 the definitions of P, C, D, and R, it follows that the percent change 
 in average-weighted rate necessary to raise the exchange from one 
 rate class to another is .05/1.87 ^ 2.7 percent, where $1.87 is the 
 average average-weighted rate of Table 2. It follows also that the 
 corresponding percent changes in the bonus and penalty bases with 
 the present and proposed constants are as shown in Table 13. 
 
 TABLE 13 
 PERCENT CHANGE IN P, C, OR D REQUIRED TO RAISE EXCHANGE 
 
 TO HIGHER CLASS 
 
 Present Percent Change Proposed Percent Change 
 
 Con- Basis Constant to Kaise to Constant to Raise to 
 
 stant Higher Rate Class Higher Rate Class 
 
 Ki Pole Line .08 2.7/.08 = 34 .34 2.7/.34 = 8 
 
 Kj Calls per Day .16 2.7/.16 = 17 .65 2.7/.65 = 4 
 
 K3 Development .02 2.7/.02 = 135 .50 2.7/.50 = 5 
 
 Thus, in order to raise the telephone company from one rate 
 class to another, the development must be increased by 135 percent, 
 an impossible increase with the present constants. With the pro- 
 posed constants, an increase in development of 5 percent will ac- 
 complish a like result. 
 
 EFFECT OF INCREASING P; HOLDING C AND D UNCHANGED 
 Miles of pole line per station is a measure of conditions against 
 which a telephone company must contend, rather than a condition 
 
 58 
 
which it would be expected to better. Thus, a telephone company 
 would obtain a bonus if it were necessary for the pole line per sta- 
 tion to be higher than the average for exchanges of the same size 
 in order that it might reach its subscribers. The company would 
 not, however, be expected to extend lines into sparsely settled re- 
 gions merely to obtain a bonus. 
 
 In order that the telephone company described in Table 12 may 
 obtain an increase in its business-one-party rate of 25 cents a 
 month, or in its average-weighted rate of 5 cents a month, by in- 
 creasing the miles of pole line per station, an increase of pole line 
 per station of 8 percent (with proposed constant) or of 34 percent 
 (with present constant) is necessary as is shown in Table 13. Ac- 
 cordingly, the miles of pole line per subscriber must be increased 
 from .075 to .081 or .100. If it is assumed that the new territory 
 is one-tenth as thickly settled as the original territory, and if x 
 represents the additional subscribers requiring, each, 0.75 miles of 
 pole line to connect them to the central office, 
 
 (150 + 0.75 x) / 2000 = .081, and x = 16, or 
 (150 + 0.75 x) / 2000 = .100, and x = 66 
 That is, with the present constants there will be required 66 sub- 
 scribers with 50 additional miles of pole line, and with the proposed 
 constants there will be required 16 subscribers with 12 additional 
 miles of pole line. 
 
 Assuming the average values of Table 2, the plant statistics 
 with the proposed and present constants would then be as follows : 
 
 With Proposed With Present 
 Constants Constants 
 
 1. Working stations 2,000 2,000 
 
 2. Miles of pole line 162 200 
 
 3. Average calls per day 10,040 10,040 
 
 4. Population of field for development 8,810 9,020 
 
 5. Development 227 222 
 
 6. Gross annual income $46,080 $46,080 
 
 7. Original gross annual income $44,880 $44,880 
 
 8. Gain in gross annual income $1,200 $1,200 
 
 9. Cost of installing necessary additional well-con- 
 
 structed pole line $7,800 $32,500 
 
 10. Cost of installing cheapest additional pole line. . . $1,200 $5,000 
 
 11 Increase in production and investment costs other 
 
 than interest corresponding to "9" $870 $3,640 
 
 12 Increase in production and investment costs other 
 
 than interest corresponding to "10" $130 $560 
 
 13. Net gain in gross income corresponding to "9". . . $330 — $2,440 
 
 14. Net gain in gross income corresponding to "10" .. . $1,070 $640 
 
 15 Maximum profitable investment corresponding 
 
 to "9".. . . $4,130 —$30,500 
 
 16 Maximum profitable investment corresponding 
 
 ■ to "10" $13,380 $8,000 
 
 17. Business-one-party rate $3.50 $3.50 
 
 59 
 
An explanation of each item and a discussion of the plant sta- 
 tistics as a whole follow : 
 
 (1) The number of working stations in each case is 2000, 
 rather than 2016, and 2066, because when the additional pole 
 line was installed, it was not assumed that any new subscribers 
 were obtained. Obtaining new subscribers relates to develop- 
 ment, and will be considered under development. 
 
 (2) As stated above, 12 and 50 miles of pole line were 
 added. Hence the total miles of pole line are 162 and 200. 
 
 (3) The calls per day per station, and therefore calls per 
 day, remain unchanged. 
 
 (4) As miles of pole line is assumed to be a measure of 
 area served, and as it has been assumed that the additional 
 territory to be served is only one-tenth as thickly populated as 
 the original territory, the populations of the original and in- 
 creased fields for development will be proportional to the miles 
 of pole line, with the additional pole line properly weighted. 
 Then, if x equals the population of the increased field. 
 
 229 
 
 1000 X 2000 — 150 
 
 _150 + 1.2 ^ ^^^ x = 8810, and 
 
 229 
 
 __15Mi5_ ^ ^jjj x = 9020 
 
 1000 X 2000 150 
 
 (5) Development is obtained by dividing the stations by 
 the population of the fields for development, and multiplying 
 by 1000 
 
 2000 2000 ^, mnn ooo 
 
 V innn — 227 nnH X 1000 = 222 
 
 8810 ^ i""" — ^'''. ana g^go 
 
 These values represent decreases of .87 percent and 3.06 
 percent from the average development, 229. As changes of 
 5 percent and 135 percent respectively are required to move a 
 telephone exchange from one class to another, the above de- 
 creases in development may, in the case under discussion, be 
 neglected. 
 
 Development, although closely associated with miles of 
 pole line per station is thus found to be negligible with re- 
 gard to rate correction. This follows from the fact that they 
 are measures of two entirely different, although dependent, 
 conditions. Miles of pole line per station is a measure of 
 sparseness of population, while development is a measure of 
 the number of people in a given population who use the tele- 
 phone, whether this population is thin and rural or thick and 
 urban. 
 
 60 
 
The interdependence of the two lies in the fact that there 
 is a natural and easily explained tendency to construct pole 
 lines first in thickly settled communities or along the high- 
 ways. In this early stage development would be low and pole 
 line per station low. As the more sparsely settled regions are 
 reached, development and miles of pole line per station would 
 both increase. However, in the case of a telephone exchange 
 of the size under consideration, development within the field 
 will bring no increase in pole line per station, but probably 
 a decrease, since it does not involve the construction of extra 
 pole line, so much as it does persuading unwilling customers 
 to buy telephone service. Thus, in order to raise miles of pole 
 line per station the telephone company must exploit new terri- 
 tory. This will increase the field for development rapidly, but 
 the stations only gradually. Therefore, as pole line per station 
 increases, development will decrease. 
 
 (6) and (7) The original gross annual income is $1.87X 
 12X2000=$44,880. The gross annual income is ($1.87+.05) 
 X12X2000=$46,080 where .05 is the bonus, corresponding 
 to the increase of 25 cents a month in the business-one-party 
 rate. 
 
 (8) The difference between (6) and (7) gives the in- 
 crease in gross annual income — in each case, $1200 — due to the 
 bonus allowed for 12 or 50 additional miles of pole line con- 
 structed. It makes no allowance, however, for the increased 
 investment and production costs due to the additional pole line. 
 
 (9) and (10) If the telephone company desired to con- 
 struct a permanent pole line with which to give good service, 
 the cost of the pole line might be assumed to be $650 a mile. 
 If, on the other hand, the additional pole line were constructed 
 merely to obtain a bonus, it would be constructed as cheaply 
 as possible, and the cost might be as low as $100 a mile. The 
 corresponding costs of the 12 miles of pole line would be 
 $7800 and $1200, and of the 50 miles of pole line, $32,500 and 
 $5000. 
 
 (11) and (12) An increased investment results in in- 
 creased production and investment costs. If pole line per sta- 
 tion is increased — average calls per station, and development 
 remaining the same — the production and investment costs, 
 other than interest, will be increased by 11.5/.6, or 19.2 per- 
 cent, less 8 percent interest, or by 11.2 percent of the additional 
 plant valuation as is shown in Table 8. If this factor is applied 
 
 61 
 
to the pole line costs of (9) and (10), the increased production 
 and investment costs other than interest will be obtained. They 
 are approximately $870, $130, $3640, and $560. 
 
 <13) and (14) The difference between these sums and the 
 gain in gross annual income of (8) gives the approximate net 
 gains in gross annual income, $330, $1070,— $2440, and $640. 
 The negative sign indicates that the increase in gross annual 
 income produced by the increase in rates will not be sufficient 
 to cover increase in production and the investment costs, other 
 than interest, chargeable to the increased investment. This 
 increase in production and investment costs would then have 
 to be paid from other sources. 
 
 (15) and (16) If the above amounts are capitalized at 8 
 percent, it will be found that the increase in rates obtained 
 by a bonus, will justify expenditures of $4130, $13,380, 
 —$30,500, and $8000 in order to obtain the bonus. 
 
 (17) This business-one-party rate, $3.50, is the old rate, 
 $3.25 plus a bonus of 25 cents obtained by the additional miles 
 of pole line per station. 
 
 An examination of the above results leads to the following 
 conclusions : 
 
 (a) The proposed constant, .34, would not quite produce 
 conditions under which the development of new territory by 
 the construction of the best telephone lines is made profitable 
 and self-supporting. The cost of 12 miles of such a line would 
 be $7800, and the expenditure which would be justified after 
 production and investment costs, other than interest, were paid 
 would be only $4130. 
 
 (b) The proposed constants would produce conditions 
 Under which the construction of the cheapest telephone lines 
 is easily justified in so far as expenditure of money is con- 
 cerned. The cost of 12 miles of such a line would be $1200 
 and the expenditure justified is $13,380. 
 
 ( (c) It would appear that the proposed constant would 
 produce conditions under which the development of new terri- 
 tory by the construction of reasonably good telephone lines 
 (costing $525 per mile) would be justified, and that such lines 
 would in general be satisfactory in new territory. If good 
 judgment is used in the selection of territory to be developed, 
 not only will the pole line bonus immediately give an increase 
 
 62 
 
in rates, but after some years, development and average calls 
 per station will increase, and additional revenue due to more 
 subscribers will add value to the investment. These additional 
 sources of revenue follow from judicious selection of the field 
 for development, careful advertisement of service, and efficient 
 management, rather than from the construction of new pole 
 line. The effect of the pole line bonus with respect to the devel- 
 opment of new fields, however, is to encourage such develop- 
 ment by making communities already established, and in 
 direct connection with the new territory, pay for it in advance. 
 
 (d) The present constant, .08, which has unconsciously 
 been applied would justify only the cheapest development. The 
 expenditure of money which would be justified to obtain a 
 bonus would be $8000, and the cost of the additional fifty miles 
 of pole line would be $5000. 
 
 (e) The present constant greatly discourages the better 
 types of new pole line construction. The increased production 
 and investment costs attendant upon the construction of fifty 
 miles of good pole line would, even after the increase in rates 
 were granted, result in an annual loss of $2440. This loss would 
 result from the investment of $30,500. In other words, the 
 present system would force the telephone company under dis- 
 cussion, in order to develop new territory, to expend over 
 $30,000, and then accept an annual loss of $2440 for several 
 years until the service is made self-supporting. This affords an 
 explanation of why only a large and wealthy telephone com- 
 pany can exploit new territory advantageously. 
 
 (f) It would thus appear that the proposed constant is 
 conservative. It might to advantage be made even greater. 
 
 EFFECT OF INCREASING C; HOLDING P AND D UNCHANGED 
 
 The average calls per day is a measure both of cost of plant 
 and cost of operation, and of the value of the service to the sub- 
 scriber. From an examination of a limited number of exchanges 
 it was indicated that the maximum busy-hour load is proportional 
 to the average calls per day. The busy-hour load or peak load on 
 the telephone exchange determines in part the size and cost of the 
 central office. In this investigation, because of the difficulty of 
 obtaining information as to the busy-hour load, busy-hour load was 
 represented by average calls per station per day. As the average 
 calls per station per day determines also the cost of operation, this 
 factor is a measure of cost. 
 
 63 
 
The use of the telephone will be greater if transmission is good, 
 if service is fast and accurate and generally satisfactory, and if the 
 management is effective. Average calls per station per day, then, is 
 also a measure of the value of telephone service to the subscriber. 
 
 If the management of the typical telephone exchange described 
 ' in Table 13 should desire to obtain a bonus for average calls per 
 station per day, an increase of 4 percent (with proposed constant) 
 or 17 percent (with present constant) would be necessary in order 
 to raise the telephone company to the next rate-class as is shown 
 in Table 13. The central-office equipment would have to be aug- 
 mented, the operating force added to, the service improved, and 
 advertised, and the good will of the public gained in order that the 
 use of the telephone might be increased. The increases of 4 per- 
 cent and of 17 percent amount to 402 calls per day and 1710 calls 
 per day. The plant statistics with the proposed or present con- 
 stants would then be: with Proposed With Present 
 
 Cozistant Constant 
 
 1. Working stations 2,000 2,000 
 
 2. Average calls per day 10,442 11,750 
 
 3. Maximum busy-hour load 1,477 1,662 
 
 4. Business-one-party rate $3.50 $3.50 
 
 5. Gross annual income $46,080 $46,080 
 
 6. Original gross annual income $44,880 $44,880 
 
 7. Gain in gross annual income $1,200 $1,200 
 
 8. Estimated increase in cost of central-office equip- 
 
 ment $530 $2,240 
 
 9. Increase in production and investment costs other 
 
 than interest $490 $2,110 
 
 10. Net gain in gross annual income $710 — $910 
 
 11. Maximum profitable investment $8,880 — $11,380 
 
 12. Surplus available for advertising and improve- 
 
 ment of service $8,350 $13,620 
 
 An explanation of each item and a discussion of the plant sta- 
 tistics as a whole follow : 
 
 (1) Working stations have not increased, as any change in 
 the number of working stations would affect development, and 
 development has been assumed to be constant. 
 
 (2) These numbers of calls are obtained by adding the 
 additional numbers necessary to raise the telephone company 
 into the next higher rate class to the average calls per station 
 per day of the typical telephone exchange described in Table 12. 
 
 (3) The maximum busy-hour load is 1420. This is ob- 
 tained by multiplying 2000 working stations by .710, a factor 
 obtained from an examination of statistics of twenty telephone 
 exchanges operating between 1000 and 3000 stations. Because 
 
 64 
 
of the fact that data in regard to only twenty telephone ex- 
 changes were available, this factor amounts to no more than an 
 indication of the relation between maximum busy-hour calls 
 and stations. The examination of these telephone exchanges 
 indicated also that maximum busy-hour load and average calls 
 per station per day vary in the same proportion. Therefore, 
 the probable maximum busy-hour loads are 1420 + (.04 X 
 1420), and 1420 + (.17 X 1420), or 1477, and 1662. 
 
 (4), (5), (6), and (7) Business-one-party rate, gross an- 
 nual income, original gross annual income, and gain in gross 
 annual income are the same as for the previous discussion in 
 regard to miles of pole line per station and are obtained in the 
 same way, 
 
 (8) The increase in maximum busy-hour load will require 
 a proportional increase in central-office equipment. According 
 to assumption, the gross annual income will amount to 34 per- 
 cent of the plant valuation. Then, if the original gross annual 
 income were $44,880, the original plant valuation must have 
 been $44,880/.34, or $132,000. If 10 percent of this plant 
 valuation is in the central office equipment, this part of the 
 plant valuation, or $13,200, will increase in proportion to the 
 maximum busy-hour loads in the two cases considered. The 
 additional amounts invested, then, are .04 X $13,200, or $530, 
 and .17 X $13,200, or $2240. 
 
 (9) An increase in the production and investment costs 
 other than interest will result from the increased traffic cost 
 which increases in proportion to the average calls per station 
 per day, and from the increased maintenance and investment 
 costs on the additional central-office equipment which is re- 
 quired. 
 
 The traffic cost is 8 percent of the plant valuation, as is 
 shown in Table 9, or in this case, $10,560. The approximate 
 increase in traffic costs in the two cases considered, with pro- 
 posed constant, and with present constant, are .04 X $10,560, 
 or $420, and .17 X $10,560, or $1800. 
 
 As may be seen from Table 9 the increase in maintenance 
 and investment costs other than interest on the additional 
 required central-office equipment is 14 percent of the additional 
 investment in central-office equipment, or in this case, $70 and 
 $310. The total production and investment costs are then 
 $420 plus $70, or $490, and $1800 plus $310, or $2110. 
 
 65 
 
(10) The net' gain in gross annual income is obtained by 
 subtracting the above increases in production and investment 
 costs from the gain in gross annual income, $1200 ,resulting in 
 the amounts $710 and — $910. The fact that the latter of these 
 amounts is negative shows that too little importance has been 
 placed upon average calls per day per station or the service 
 factors of which it is an indication, since the increase in pro- 
 duction and investment costs alone is greater than the gain 
 in income resulting from the rate bonus. Hence, with the 
 present constants, a betterment in transmission, speed and 
 accuracy of service, and efficiency of management which would 
 result in increased calls would be penalized. 
 
 (11) If the net gains in gross annual income are capital- 
 ized at 8 percent, there will be obtained the maximum expen- 
 ditures which would result in profit to the telephone company. 
 These are $8880, and $11,380. 
 
 (12) The sums available for advertising and improving 
 service are the difference between the maximum profitable ex- 
 penditures and the costs of additional required central-office 
 equipment. These are $8880 — $530, or $8850, and — $11,380 
 — $2240, or — $13,620. 
 
 If a proposed bonus and penalty constant of 0.40 instead 
 of 0.65 is used, a 7 percent increase in average calls per station 
 per day will be required to raise the exchange to the next higher 
 rate class. The net gain in gross annual income will be $1200 
 —$880, or $320, which would justify an investment of $4000. 
 As the increase in the cost of the central-office equipment is 
 $920, $3080 would be left for advertising and service improve- 
 ment. 
 
 An examination of the above results leads to the following 
 conclusions : 
 
 (a) The proposed constant, 0.65, is too liberal. The 
 amount available for advertising and improving the service 
 should be more than ample. It will probably be found that a 
 smaller constant as 0.40 will be sufficient to encourage tele- 
 phone companies to better their service and incur expenses 
 of advertising in order to obtain bonuses. 
 
 (b) The present constant 0.16 is too small. It will be seen 
 that an effort to obtain a bonus will make it necessary for the 
 telephone company to make an annual expenditure in produc- 
 
tion and investment costs which exceeds the gain in gross an- 
 nual income by nearly $1000. An improvement in service would 
 thus result in a financial loss, and the telephone company would 
 be penalized for improving its service. 
 
 In the above discussion, it has been assumed that no sub- 
 scribers would be added. Any advertising campaign, or im- 
 provement of service would obtain new subscribers for the 
 telephone company, and, therefore, increase development. How- 
 ever, unless the advertising campaign were especially directed 
 toward this end, an increase in the number of subscribers suffi- 
 cient to cause an increase to a higher rate due to an increase 
 in development only would not be probable. In actual practice, 
 such a campaign would not be directed toward either end to 
 the exclusion of the other, but the rate increase would finally 
 result from the summation of the effects of both. However, 
 in this discussion, the purpose of which is to determine the 
 justice of the values assigned to the constants, it is, of course, 
 necessary to consider them separately rather than as operating 
 simultaneously. 
 
 EFFECT OF INCREASING D; HOLDING P AND C UNCHANGED 
 
 Development is primarily a measure of the value of the tele- 
 phone service to the subscriber, but to obtain a development which 
 is greater than the average, the telephone company must incur 
 expenses of operation and management ; hence cost is also involved. 
 
 In order to obtain greater than the average development, trans- 
 mission must be improved, and plant troubles which directly affect 
 the subscriber decreased, greater speed and accuracy of service 
 developed, business methods adapted to the needs of the commu- 
 nity, the telephone service advertised, and the service bettered in 
 many other ways. 
 
 In order, by improving the service, so to increase development 
 that a bonus of 25 cents a month is justified, there will be required 
 an increase of 5 percent in development (with proposed constant) 
 or 135 percent (with present constant) as shown by Table 13. This 
 increase will be applied to the business-one-party rate $3.25 a month 
 of the typical telephone exchange described in Table 12. Assuming 
 that the population of the field for development is constant, these 
 increases in development, would, involve changes in stations of 100 
 or 2700, or from 2000 to 2100, or 4700. 
 
 Statistics in regard to the' telephone exchange after the devel- 
 opment with proposed and pfesent constants necessary to earn the 
 
 67 
 
bonus had been reached, and the rate increase granted would be as 
 follows : 
 
 With Proposed With Present 
 Constant Constant 
 
 1. Working stations 2,100 4,700 
 
 2. Population of field for development 8,750 8,750 
 
 3. Rate for business-one-party service $3.50 $4.25 
 
 4. Gross annual income $48,400 $116,700 
 
 5. Original gross annual income $44,880 $44,880 
 
 6. Gain in gross annual income $3,520 $71,820 
 
 7. Increase in cost of equipment $6,600 $178,200 
 
 8. Increase in production and investment costs other 
 
 than interest $1,720 $46,400 
 
 9. Net gain in gross annual income $1,800 $25,420 
 
 10. Maximum profitable investment $22,500 $317,750 
 
 11. Justified expenditure for service improvement 
 
 and advertising $15,900 $139,550 
 
 12. Justified yearly expenditure for service improve- 
 
 ment and advertising $1,270 $11,160 
 
 13. Justified yearly expenditure for service improve- 
 
 ment and advertising per additional station $13 $4 
 
 An explanation of each item and a discussion of the statistics 
 as a whole follow : 
 
 (1) and (2) The percentages of increase in development 
 required to obtain a bonus, 5 and 135 percent, represent 100 
 and 2700 stations. The total stations then are 2100 and 4700. 
 The population of the field for development has been assumed 
 constant. 
 
 (3) The rate after a bonus has been obtained with the pro- 
 posed constant is $3.25 plus $.25, or $3.50 a month. The 4700 
 stations required to obtain a bonus with the present constant, 
 place the telephone company in Class No. 9, the business-one- 
 party rate of which is $4.00 a month as is shown by Table 11. 
 Then, the bonus for development would raise this rate to $4.25 
 a month. The corresponding average-weighted rate is $2.07 
 a month. 
 
 This number of stations in a community of this size is im- 
 probable. The development would be 538 telephones per thou- 
 sand people. Such a development would require that there be 
 a telephone, and in many cases, several telephones in every 
 home and place of business. Such a condition could not be 
 found, but it would be necessary with the present constant in 
 order that a bonus might be obtained for development. 
 
 (4), (5), and (6) The original gross annual income is the 
 average weighted rate before the bonus was granted times the 
 
 68 
 
number of stations, or $1.87 X 12 X 2000, or $44,880. After 
 granting the bonus, the gross annual income is $1.92 X 12 X 
 2100, with the proposed constant, and $2.07 X 12 X 4700, with 
 the present constant, or $48,400, and $116,700. The differ- 
 ences between the gross annual incomes and the original gross 
 annual incomes, or $3520, and $71,820, are the gains in gross 
 annual income. 
 
 (7) and (8) As the original gross annual income is 
 $44,880, and as this, as shown in Table 7 is 34 percent of the 
 plant valuation, the plant valuation is $132,000. As may be 
 seen from Table 10, the production and investment costs other 
 than interest which were originally 26 percent of the plant 
 valuation $132,000, or $34,300 increase in proportion to devel- 
 opment. The increases in production and investment costs oth- 
 er than interest then are $1720 and $46,400. The plant valu- 
 ations also increase in like proportion. The increases in plant 
 valuation are $6600 and $178,200. 
 
 (9) The net gain in gross annual income is the difference 
 between the gain in gross annual income, and the increase in 
 production and investment expenses other than interest. In 
 this case with proposed and present constants, the net gains in 
 gross annual income are $1800 and $25,420. 
 
 (10) and (11) The net gains in gross annual income capi- 
 talized at 8 percent will produce the amounts which may profit- 
 ably be invested in obtaining the bonus. These amounts are 
 $22,500 and $317,750. These amounts less the increases in 
 cost of equipment of (7) are the amounts, $15,900 and 
 $139,550, the justified expenditure for service improvement 
 and advertising. 
 
 (12) and (13) Assuming that the interest at 8 percent on 
 the justified expenditure for service improvement and adver- 
 tising is spent for these purposes, the justified yearly expendi- 
 tures for service improvement and advertising with the pro- 
 posed and present constants will be $1270, and $11,160, and 
 the corresponding justified yearly expenditures per additional 
 station for service improvement and advertising will be $18 
 and $4. As the cost per station of obtaining 2700 additional 
 stations in a field for development with a population of 8750 
 will be very high, $4 per station will certainly be inade- 
 quate. As it will probably not be difficult to obtain 100 addi- 
 
 69 
 
tional stations in such a field, $13 will probably be more than 
 sufficient. 
 
 An examination of the above results leads to the following 
 conclusions : 
 
 (a) The proposed constant 0.50 is adequate, and probably 
 too liberal. 
 
 (b) The present constant, 0.02, is too low and makes it 
 unwise for a telephone company to attempt to obtain a bonus 
 by increasing development. 
 
 (c) A constant less than 0.50 and much greater than .02 
 would probably be just. If the cost of improving and advertis- 
 ing the service to the extent necessary to obtain the additional 
 stations were known, a positive determination of the proper 
 constant could be made. In the absence of such data, the most 
 reasonable assumption is that the best value of the constant 
 would be an average value between the present and proposed 
 constants, or 0.26. It is not to be expected that a value con- 
 stant can be determined as definitely as a cost constant. 
 
 THE PROPOSED BONUS AND PENALTY CONSTANTS 
 
 It would appear, then, that the best values of the constants 
 would be : 
 
 K, = 0.34, K, = 0.40, and Ks = 0.26, 
 
 and the deviation equation becomes : 
 
 0.34P + 0.40C -1- 0.26D — R. 
 
 It is to be noted that although these constants are larger than 
 the present ones, 0.08, 0.16, and 0.02, their order of importance is 
 the same. 
 
 SECTION X. APPLICATION OF RATE-STANDARDIZATION 
 
 PLAN 
 
 The proposed rate standardization plan will provide rates which 
 are in the average case just to telephone companies and subscrib- 
 ers at the present time, because in communities of any given size 
 they are based upon average rates, which, as explained above in 
 Section VI, are average production costs plus investment costs on 
 normal plant costs. 
 
 70 
 
ADJUSTMENTS NECESSARY TO CARE FOR CHANGES IN PRICE LEVEL 
 AND DEVELOPMENTS IN THE ART OF TELEPHONY 
 
 The proposed plan does not, however, make any adjustments 
 for rapid changes in price level, such as those of the past five years, 
 nor does it make any adjustments for new developments in telephone 
 equipment or methods of operation. 
 
 If the general price level of all commodities should rise rapidly, 
 rate increases would be granted only after considerable delay. The 
 production and investment costs of the telephone companies would 
 increase rapidly following the change in price level, and the income 
 of the telephone companies would not be sufficient to cover the 
 costs. If, on the other hand, the price level should fall rapidly, 
 the result would be an income to the telephone company greater 
 than sufficient to cover the production and investment costs. The 
 surplus income should fairly be distributed to the telephone sub- 
 scribers by decreases in rates. 
 
 If developments in the art of telephony make the production of 
 telephone service more economical as well as more satisfactory, the 
 telephone companies should not derive all of the benefit from them, 
 and rate decreases should follow ; although, on the other hand, the 
 rate decreases should not be so great that the telephone subscribers 
 will derive all of the benefit from the development. 
 
 In order to forestall these possible disadvantages, the public- 
 utility commissions must at times make arbitrary adjustments in 
 the average rates. Some plan must be provided by which the public- 
 utility commissions may be informed at all times of the average 
 rates and of the conditions which would justify bonuses or penal- 
 ties ,and, having information in regard to changes in average rates, 
 they must make any necessary arbitrary adjustment promptly. 
 
 METHODS OF APPLICATION OF RATE-STANDARDIZATION PLAN 
 
 One plan which would be satisfactory would be for the public- 
 utility commissions to keep continuous records of production and 
 investment costs, and the statistics from which may be obtained, 
 miles of pole line and conduit per station, maximum busy-hour call- 
 ing-rate, average calls per station per day, and development. From 
 these data, the bonuses and penalties and new average rates to be 
 applied may be obtained. These data in the form of annual or semi- 
 annual reports should be obtained separately for each exchange in 
 the state, whether or not the various telephone companies operate 
 one or a number of exchanges. 
 
 The work on the part of the telephone companies necessary to 
 prepare these reports would not be burdensome. The advantage 
 
 71 
 
to the telephone company of keeping financial accounts has been 
 conceded. Similar advantages would result from plant and traffic 
 accounts which would be made necessary by this plan. They would 
 suggest to the telephone companies many improvements and econ- 
 omies. 
 
 From these data may be obtained the average curves, constants, 
 and statistics for groups of exchanges of various sizes. These will 
 be the data for average typical exchanges, similar to the data of 
 the typical exchange of 2000 stations discussed in this report. The 
 knowledge on the part of those interested in the production of tele- 
 phone service of what are typical telephone exchanges will be valu- 
 able for comparative purposes. 
 
 The allowable average-weighted rate will be assigned by the 
 public-utility commission and the choice of a rate schedule should 
 be left to the telephone company, as suggested in Section IX. 
 
 A public-utility commission obviously cannot make an arbitrary 
 adjustment of rates for each small change in production and invest- 
 ment costs. It is desirable, in fact, to make such adjustments as 
 infrequently as possible. A minimum change in production and in- 
 vestment costs may be chosen, such as 10 percent, below which 
 arbitrary adjustments will not be made. If it should become appar- 
 ent to a public-utility commission that this minimum change may 
 be exceeded, all necessary information may be collected and exam- 
 ined, and other preparations made to adjust the rates without delay 
 when the minimum change has been exceeded. Such a procedure 
 may well apply to changes in production and investment costs re- 
 sulting from any causes such as changes in price level, or economies 
 due to developments in the art of telephony. 
 
 NECESSITY FOR PERIODICAL VALUATIONS OF TELEPHONE PLANT 
 
 It is not reasonable to suppose that this plan for rate standard- 
 ization could be applied indefinitely without such a check upon plant 
 valuation and, therefore, upon investment costs, as would result 
 from reappraisals of the telephone plants. Such reappraisals should 
 be made on a state-wide basis at chosen intervals — every ten years 
 for instance — and the continuous records modified accordingly if 
 necessary. If such reappraisals were made periodically in this way, 
 they would be sufficient check upon the continuous records, and 
 would be much less costly than the unending series of appraisals 
 and reappraisals and valuations of individual telephone plants which 
 are necessary under the present system of rate determination. The 
 work of the public-utility commissions would be decreased to such 
 an extent that attention could be given to service standards and 
 their enforcement. 
 
 72 
 
ADDITIONAL PROBABLE REQUIREMENTS IN APPLICATION OF 
 RATE-STANDARDIZATION PLAN 
 
 It will be necessary to apply this rate-standardization plan to 
 sections of the country which are homogeneous. Confusion might 
 be caused by an attempt to apply the average rate curves and con- 
 stants of one section to one of a widely different character. How- 
 ever, more just results might be obtained in some cases by consider- 
 ing a number of states of the same general character together rath- 
 er than separately, for, in this way, a tendency of one public-utility 
 commission to be unfair to one or the other of the parties concerned 
 might be balanced by an opposite tendency of another public-utility 
 commission. 
 
 While in the preceding discussion of proposed bonus and pen- 
 alty constants only the average station-rate curves of Group 4 of 
 Ohio telephone companies with the corresponding data of Table 2 
 were considered, if the rate standardization plan were applied to 
 Ohio, an average of the curves of Groups 1, 2, 3, and 4, and the 
 corresponding data would be used. The average of the curves for 
 exchanges of more than from 1000 to 1500 stations will probably 
 provide rates which cover the cost of producing the telephone serv- 
 ice and which will, therefore, be a just basis for rate determination 
 at the present time. The average of the curves for exchanges of 
 less than from 1000 to 1500 stations will probably provide rates 
 which are not compensatory, and will have to be arbitrarily adjusted 
 by the public-utility commissions. 
 
 If communities in which the telephone service is on a message- 
 rate basis are included in the group of communities to which this 
 rate standardization plan is applied, its average operating income 
 per station will determine its position on the curve of average- 
 weighted rates. Bonuses and penalties must then be applied to 
 average operating income per station. 
 
 It should be noted that an advantage of this rate-standardiza- 
 tion plan is that its adoption would not result in any radical change 
 in rates, as the average rates are averages of those rates now in 
 force. 
 
 APPLICATION TO OTHER PUBLIC-UTILITY RATES 
 
 While this investigation has been confined entirely to the stand- 
 ardization of telephone rates, the proposed plan can be applied also 
 wholly or partially to the standardization of electric light and power 
 rates, water, gas, and street railway rates, or, in other words, to all 
 public-utility rates, 
 
 73 
 
SECTION XI. SUMMARY 
 
 The faults of the present "cost plus" system of rate determin- 
 ation have been pointed out (Section II) . A plan for rate standard- 
 ization which will eliminate the worst of these faults, and which is 
 practical has been proposed and discussed (Sections III, IV, and V) . 
 It has been shown that station-rate curves may be made which 
 show the relation between numbers of stations served by exchanges 
 and rates. These station-rate curves are based upon normal costs 
 which are receiving serious consideration as a basis for rate de- 
 termination. Typical station-rate curves for Ohio have been plotted 
 and discussed (Section VI) . The rate-deviation equation has been 
 presented (Section VII), and applied to present telephone rate con- 
 ditions in Ohio and other Middle West states. The solution of this 
 equation shows what importance has been attached to the proposed 
 bonus and penalty bases. Just bonus and penalty constants have 
 been proposed (Section VIII) and carefully analyzed and modi- 
 fied (Section IX). The rate-deviation equation with bonus and 
 penalty constants which should have been applied is presented (Sec- 
 tion IX) . The method of applying the proposed plan for rate stan- 
 dardization has been discussed (Section X). 
 
 The proposed plan offers an incentive to telephone companies 
 to provide the best possible telephone service, and thus corrects the 
 worst fault of the present system of rate determination. The 
 adoption of the proposed plan would decrease the present burden 
 upon the utility commissions and the telephone companies, and 
 would eliminate some of the injustice and indefiniteness of the 
 present system. Under the proposed system, quality of telephone 
 service rather than cost of service is emphasized and a general 
 improvement of telephone service may, therefore, be predicted as a 
 result of the application of the proposed plan for rate standard- 
 ization. 
 
 74 
 
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