Incentive regulation and allocative efficiency: Evidence from the U.S. telecommunications industry

Rate of return regulation in the telecommunications industry was enacted in 1934 to promote universal and affordable service in an industry dominated by the Bell system. The Federal Communication Commission (FCC), which was the regulatory agency at the time, aimed to allow Bell companies to cover all of the participating firms' necessary costs, including a fair return on the capital employed as an incentive to provide universal service. Decades later observers realized that there were several aspects of rate of return regulation which led researchers to question whether this industry's regulatory policy was still appropriate. Most of the criticism focused on the lack of incentives to minimize cost. Incentive regulation, such as price caps, provided an alternative for the telecommunications industry which was implemented in 1989. This dissertation focuses on allocative efficiency in the telecommunications industry and compares the result of firms facing rate of return and price cap regulation. Allocative inefficiency arises because firms facing rate of return regulation maximize their profits by over-investing in capital, also known as the A-J effect. An estimate using a simple translog cost function in a parsimonious model from this dissertation reveals that telecommunication firms invest in an inefficiently high amount of capital relative to labor, whether facing rate of return or price cap regulation. To examine technology's effect on efficiency this dissertation uses a more complete model by adding key variables, such as the percentage of digital switches, Bell operating system, firm dummy variable, and time dummy variable to capture the technology change and control for fixed effects. The results from estimating the alternative cost equation reveals that the introduction of cost-saving technology explains the inefficiency findings from telecommunications carriers facing price cap regulation in the parsimonious model. In contrast, the inefficiency results persisted for telecommunications carriers facing rate of return when controlling for inter-carrier differences in investment of cost-saving technology. The finding also shows that firms facing price cap regulation use inputs, including capital, closer to the unconstrained optimal level suggesting improvement in allocative efficiency. This crucial result suggests that price cap regulation apparently provides incentives for firms to increase allocative efficiency.