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By Jaison R. Abel, Ph. D.
September 2000

By the year 2000, over 75 percent of the state public utility
commissions in the United States had selected price-cap regulation to
constrain the operations of the major telephone companies within their
states. Since the majority of these decisions were made in the mid
i 990s, several state commissioners now face renewal decisions. In
addition, many of the state public utility commissions that continue to use
traditional rate-of-return regulation are contemplating a switch to price-cap
regulation. Therefore, understanding the affects of this popular form of
incentive regulation in the United States telecommunications industry will
prove useful to state commissioners confronting decisions about the type
of regulation they will choose to implement in the new millennium. This
report focuses just on price caps at the state level and does not analyze
any other forms of incentive regulation.
By providing an up-to-date review of the empirical econometric
academic literature on price caps, this report provides a comprehensive
assessment of the performance of the telecommunications industry under
price-cap regulation. This review focused on seminal research
contributions as well as empirical research completed since the passage
of the 1996 Telecommunications Act. In order to add context to this
review, the theoretical properties of price-cap regulation are compared to
the price-cap plans found in practice. In most cases, the theoretical ideal
of price-cap regulation has been greatly modified once applied. In
addition, this report provides a uniform framework to critique empirical
research about the impact of price-cap regulation intended to assist
commission staff tasked with evaluating empirical evidence put forth
during regulatory hearings.
Two distinct themes arise from the empirical evidence put forth to
date. First, the behavioral response by telephone companies has
generally been more pronounced under pure price-cap regulation than
under hybrid price-cap plans that contain an earnings-sharing component.
This important finding provides evidence in support of the idea that
regulated firms respond to the incentives they face, and is consistent with
the body of theoretical literature analyzing incentive regulation.
Second, the industry as a whole has responded favorably to the
incentives created by price-cap regulation. In particular, price-cap
regulation is associated with lower telephone prices, higher productivity,
more network modernization, and firm financial performance that is no
worse than that realized under alternative methods of regulation. Third,
the results for service quality are best characterized as mixed: price-cap
regulation is associated with fewer customer complaints, but longer repair
times. Fourth, the empirical research has uncovered a relationship
between the adoption of price-cap regulation and the competitive
transition now taking place in the local telephone industry. Price-cap
regulation is associated with less net entry by competitors, smaller
cumulative competitive fringes, and has also been shown to influence the
level at which arbitrated interconnection prices are set by state
commissions. This is a particularly promising line of inquiry for new
research aimed at understanding how price-cap regulation affects
industry performance.
The report concludes that new and improved research is necessary
before definitive conclusions about the performance of the United States
telecommunications industry under price-cap regulation can be made.

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