Relative prices, incentives, and the move to automated telephone switching

This week in my ECONS101 class, we talked about the Industrial Revolution. Specifically, we used a relatively simple production model to show how changes in the relative price of coal and labour in England created incentives for firms to switch from using labour-intensive production technologies to using coal-intensive production technologies.

That model, and the associated explanation, can be used in a range of situations. For example, I previously used it in a post about taxing robots. However, in this post I want to talk about telephone switching. The Federal Reserve Bank of Richmond's Econ Focus had an article about telephone operators late last year:

Users of the telephone in the late 19th century and early 20th century couldn't dial their calls themselves. Instead, they picked up their handset and were greeted by an operator, almost always a woman, who asked for the desired phone number and placed the call. Technology to automate the process emerged quickly, however: The first automated telephone switching system — a replacement for human operators and their switchboards — came into use with much fanfare in La Porte, Ind., on Nov. 3, 1892, 16 years after Alexander Graham Bell's patent on the telephone.

Yet telephone companies continued relying on the women long afterward. In 1910, only around 300,000 telephone subscribers had automatic service — that is, service in which they dialed calls themselves rather than interacting with an operator — out of more than 11 million subscribers total. The companies of the Bell System did not install their first fully automated office until Dec. 10, 1921, and did not install an automated system in a large city until the following year, two decades after the technology had been demonstrated. Those telephone users who did have access to automated calling were customers of independent phone companies, mostly in small towns and rural areas.

This raises a couple of questions. First, why did the telephone companies switch from human operators to automated switching systems? Second, why did this change happen in small towns and rural areas before big cities? The simple production model can help us explain.

Let's start by setting up the simple production model. It is shown in the diagram below, with capital (e.g. automated switching) on the y-axis and labour on the x-axis. Let's say that there are only two production technologies available to telephone companies, A and B, and that both production technologies would produce the same quantity (and quality) of output (connected telephone calls) for the combination of inputs (capital and labour) shown on the diagram. Production technology A is a labour-intensive technology (human operators) - it uses a lot of labour, and supplements the labour with a bit of capital. Production technology B is a capital-intensive technology (automated telephone switching) - it uses a lot of capital, and a small amount of labour (for keeping the switching machines operating).

How should a telephone company choose between the two competing production technologies A and B? If the firm is trying to maximise profits, then given that both production technologies produce the same quantity and quality of output (connected telephone calls), the firm should choose the technology that is the lowest cost. We can represent the firm's costs with iso-cost lines, which are lines that represent all the combinations of labour and capital that have the same total cost. The iso-cost line that is closest to the origin is the iso-cost line that has the lowest total cost. The slope of the iso-cost line is the relative price between labour and capital - it is equal to -w/p (where w is the wage, and p is the cost of a 'unit' of capital).

First, consider the case where labour is relatively cheap and capital is relatively expensive. The iso-cost lines will be relatively flat, since w is small relative to p (so -w/p is a small number). In this case, the iso-cost line passing through A (ICA) is closer to the origin than the iso-cost line passing through B (ICB), as shown in the diagram below. So production technology A is the least-cost production technology, and firms should use the relatively labour-intensive production technology (human operators).

Now consider what happens if wages are higher, or the cost of capital is lower. The relative price between labour and capital (-w/p) would increase, and the iso-cost lines would get steeper. This is shown in the diagram below, where the iso-cost line passing through B (ICB') is now closer to the origin than the iso-cost line passing through A (ICA'). So, now production technology B is the least-cost production technology, and firms should use the relatively capital-intensive production technology (automated telephone switching).

So, we already know that telephone companies switched from A to B, and we have an explanation of why it might have happened. Is our model's explanation consistent with the facts? In terms of wages, most telephone operators were women. Going back to the article in Econ Focus:

At first, the telephone industry hired men and boys as operators. But the practice was short-lived. The first woman operator, Emma Nutt, was hired by a telephone service in Boston in 1878, and the hiring of women spread quickly. Women operators were viewed by the companies as more polite to customers, more patient, more reliable, and faster — not to mention cheaper.

That last point is relevant to our model - wages of telephone operators were low. What about the cost of capital? From the article:

The difference with automatic telephone switching was that the cost structure, perhaps surprisingly, favored the smaller firms with their smaller customer bases. With the electromechanical systems of the day, each additional customer was more, not less, expensive. Economies of scale weren't in the picture. To oversimplify somewhat, a network with eight customers needed eight times eight, or 64, interconnections; a network with nine needed 81.

"You were actually getting increasing unit costs as the scope of the network increased," says Mueller. "You didn't get entirely out of the telephone scaling problem until digital switching in the 1960s."

So, the cost of automated telephone switching was higher in larger markets (e.g. large urban areas) than in smaller markets (small towns or rural areas). So, it seems likely then that the relative price of labour to capital (-w/p) was low (low wages, high cost of capital), and even more so in large urban areas. This makes the iso-cost lines flat (and flatter in large urban areas), which favours the labour-intensive technology.

But later:

Together with refinements in the technology, probably the foremost factor was wage inflation during and after the Great War — what is known today as World War I.

Following the war, a steep rise in the wages of the labor pool from which telephone companies drew telephone operators was enough to jolt Bell management into rethinking its attitude toward automatic switching. Thus the Bell System began planning in 1919 to adopt automation.

The increase in wages increases the relative price of labour to capital (-w/p), making the iso-cost lines steeper, and favouring the capital-intensive technology. The change to capital-intensive technology didn't happen overnight though. Sometimes incentives take a while to be acted on:

In 1965, the year after Baker's forecast, the Bell System installed its first permanent fully electronic switching system in Succasunna, N.J.

Digital switching, which was introduced in the 1960s, lowered the price of capital, which in our model makes the iso-cost lines even steeper, and increasing the incentives for telephone companies to switch to automated (digital) telephone switching. As you can see, the simple production model that my ECONS101 class uses in the very first week is quite versatile in explaining changes in production over time.

[HT: Marginal Revolution]