Price Caps in Telecommunications Regulatory Reform

by Leland Johnson

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There has been a longstanding debate about the perverse incentives associated with the "cost plus" nature of rate-of-return (ROR) regulation. The notion of imposing price caps as a substitute for ROR regulation has attracted attention because it (1) severs the relationship between prices and costs and rewards a firm with the savings it achieves through efficiency; (2) severs the connection between profits and rate base, eliminating the rate base bias; (3) restricts a firm's ability to hike prices charged monopoly ratepayers to finance predatory undertakings in competitive markets by imposing price ceilings on monopoly services; (4) reduces administrative burden by offering clear criteria for enforcement; and (5) encourages the firm to move toward socially optimal prices by giving it greater pricing flexibility. This Note considers the benefits of price caps compared with ROR regulation. The author draws on basic economic theory supplemented by evidence from filings with the Federal Communications Commission and from Britain's experience with price cap regulation. Among his findings, the author concludes that, under a wide range of circumstances, price cap regulation will probably achieve results superior to those of traditional ROR regulation.

This report is part of the RAND Corporation Note series. The note was a product of the RAND Corporation from 1979 to 1993 that reported other outputs of sponsored research for general distribution.

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