Implementing Price Caps in Telecommunications

Abstract

Over the past few years, price caps have replaced rate‐of‐return regulation in many sectors of telecommunications. This article focuses on the key implementation issues raised in the Federal Communications Commission's formulation of price cap plans for AT&T and the local telephone exchange carriers. Specifically, it discusses company cost changes over time and the formulas employed to track costs; the multiplicity of prices and the structure of regulations designed to cap them; and the inevitability of errors in the long run and the disincentives likely to result from efforts to correct such errors. It concludes with an evaluation of the performance of these price cap plans, noting how the resolution of these various issues has affected plan success.

Incentive Regulation in Theory and Practice: Electricity Distribution and Transmission Networks

“…Because prices are fixed (or vary based only on exogenous indices of cost drivers) and do not respond to changes in managerial effort or ex post cost realization , the firm and its managers are the residual claimants on production cost reductions and the costs of increases in managerial effort (and vice versa). That is, the firm and its managers have the highest powered incentives fully to exploit their cost opportunities by exerting the optimal amount of effort (Brennan 1989;Cabral and Riordan 1989;Isaac 1989;Sibley 1989;Kwoka 1993). Accordingly, this mechanism provides optimal incentives for inducing managerial effort and eliminates the costs associated with managerial moral hazard.…”

“…In addition, W will be reduced if excessive rents are left to the firm since this will require higher (second-best) prices and greater allocative inefficiency. Laffont and Tirole (1988, 1993, 2000) create a social benefit from reducing the rents left to the firm in a different way. In their basic model, consumer welfare and the welfare of the owners and managers of the firm are generally weighted equally.…”

“…These dynamic issues have been examined theoretically more intensively over time and represent a merging of the literature on regulation with the literature on contracts and dynamic incentive mechanisms more generally. (Laffont and Tirole 1988b, 1990a, 1993Baron and Besanko 1987a;Vickers 1991, 2000; Cowan and Vickers 1995) The impacts of regulatory lag of different durations (Baumol and Klevorick 1970, Klevorick 1973, Joskow 1974) and other price adjustment procedures have been analyzed theoretically as well (Vogelsang and Finsinger 1979;Sibley 1988, 1990).…”

The effects of incentive regulation in the telecommunications industry: A survey

“…See Sappington and Weisman (1996a), Armstrong, Cowan, and Vickers (1994), BellSouth (1994), Blackmon (1994), Braeutigam and Panzar (1993), Kwoka (1993), Mitchell and Vogelsang (1991), Braeutigam and Hillman (1989), Beesley and Littlechild (1989), and Vickers and Yarrow (1988) for more detailed descriptions of how price-cap plans operate in practice. Among the many formal analyses of the merits and drawbacks of price-cap regulation are: Braeutigam and Panzar (1989), Brennan (1989), Brown, Einhorn and Vogelsang (1989), Cabral and Riordan (1989), Lewis and Sappington (1989), Schmalensee (1989), Isaac (1991), Sappington and Sibley (1992), Laffont and Tirole (1993), and Gasmi, Ivaldi, and Laffont (1994).…”

Price Cap Policies in the Transition from Monopoly to Competitive Markets1

“…A formula offered the possibility of reducing regulatory debates to a few key parameters: plan duration and adjustments for changes in input prices, technology, and key developments outside the firm's control, such as a change in tax rates or depreciation policy. In addition, Kwoka (1993) pointed out that the design of price caps required that attention be given to baskets, bands, floors, and ceilings. In some regulatory applications, simplicity has been sacrificed for the achievement of greater public acceptance.…”