NCPA - National Center for Policy Analysis

Price Caps Preferable To Guaranteed Profits

March 3, 1999

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.


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