State policymakers are facing crucial choices regarding the regulation of telecommunications, say analysts. Traditionally, local telephone services have been regulated to ensure a "fair" profit above their costs. This system is commonly known as "rate-of-return" regulation. This creates perverse incentives for a firm to increase its costs and pass them on to consumers.

But state regulators are using alternative methods in which prices -- rather than profits -- are regulated, giving providers an incentive to increase efficiency and lower costs. Commonly known as "incentive regulation," it usually takes the form of a price cap. Price cap regulation was first applied to the newly privatized British Telecom in 1984.

• The idea spread, and in June 1989 the Federal Communications Commission (FCC) instituted a price cap system for AT&T long-distance service, and in 1990 for the interstate activities of local telephone companies.

• By 1995, nearly 35 states were using incentive-based systems in intrastate markets, according to a CSE Foundation survey.

• By 1996, 24 of the states were using price cap regulation and 36 states in all were using some form of incentive- based regulation.

Academic studies suggest price caps do not harm service quality and improve many measures of success. Chunrong Ai and David E.M. Sappington conclude that:

• "Network modernization is more pronounced under incentive regulation than under rate-of-return regulation."

• "The deployment of fiber optic cable is more pronounced...."

• "The fraction of network lines served by modern switches is higher...."

• And "residential basic local service rates are lower...."

Initial price caps are either frozen or periodically adjusted, based on an inflation index, and often a "productivity factor." Under a price cap system, inefficient firms make a lower profit than they would under a rate-of-return system.

Source: Kent Lassman, "A Primer on Price Cap Regulation," Issue Analysis No. 85, February 25, 1999, Citizens for a Sound Economy Foundation, 1250 H Street, N.W., Suite 700, Washington, D.C. 20005, (202) 783-3870.