Issue Analysis 85 – A Primer on Price Cap Regulation

Oregon legislators are considering a proposal that would modernize the regulation of the telecommunications marketplace. This would be achieved by redirecting the focus of regulators from companies toward consumers.

America’s legislators have learned two important lessons from deregulation of the banking, trucking and airline industries. First, regulation has an impact on everyone. Second, it is important to decide both whether to regulate and how to regulate. Today, these lessons can be brought to bear on the market for local telecommunications services. This paper provides a background on the key concepts of rate-of-return, price cap, and incentive regulation. This paper is not a legislative analysis; it offers neither advocacy nor opposition to any specific legislation.

Traditionally, local telephone services in Oregon and elsewhere have been regulated to ensure a “fair” profit above their costs. This system is commonly known as “rate-of-return” regulation. Under this system regulators establish a permissible rate-of-return, which is enough to cover the company’s costs, plus a “reasonable” profit that allows the industry to attract necessary capital investment. The primary problem of a regulatory system that is based on costs is the creation of perverse incentives – a firm can increase its costs and pass them on to consumers without diminishing its profit. To add insult to injury, a firm can earn even larger returns by simply spending more money.

Recognizing this problem, more and more state regulators across the country have been moving to alternative methods of regulation in which prices – rather than profits – are regulated, giving providers an incentive to increase efficiency and to lower costs.1

Legislation has been introduced in the Oregon Senate, SB-142, that would allow telecommunications firms to opt out of rate-of-return regulation in favor of price cap regulation. Should a firm choose price cap regulation, it is also required to contribute to a state universal service fund and to invest in rural telecommunications infrastructure.

Competition vs. Regulation. Regulated markets are a poor substitute for competition. Unlike a regulatory system, which is dependent upon the information and knowledge of five regulators in Washington, D.C., or a few in Salem, a competitive market harnesses the intelligence, expertise, and energy of every consumer and producer in the marketplace. Price signals generated by market transactions ensure that resources are allocated efficiently. The results are lower prices, improved quality, and an increased rate of innovation.

This is why, when competition exists in any telecommunications market, policymakers should allow markets and consumers – rather than regulators – to determine prices and services. SB-142, in fact, would move Oregon in this direction by creating the opportunity for full price flexibility in the emerging markets of data transport.2 When rate-of-return regulation was introduced, telecommunications services were primarily limited to broadcast television, voice-grade telephone service, and the telegraph. Today’s reliance on computers, facsimile machines, and the Internet has created a competitive marketplace for data-intensive services.

In markets where there is no competition, and where some regulation is still considered necessary, there are still critical decisions that policymakers must make as to the type of regulation that is applied. One of the most fundamental choices is whether to employ rate-of-return, or profit-based regulation, or to use an alternative, price-based system.

Rating “Cost-Plus” Regulation. The nuts and bolts of traditional rate-of-return regulation are relatively simple. In form, it is similar to a “cost-plus” contract of the sort awarded by the Defense Department. A regulated company is allowed to charge rates that cover its costs, plus a “fair rate-of-return.” This rate-of-return is typically based on the firm’s equity or capital.

Though rate-of-return regulation limits profits by guaranteeing a return on investment, it also eliminates many of the risks associated with poorly performing investments. Moreover, this type of regulation provides telephone companies with little incentive not to be wasteful. Even if a firm spends more than necessary, it still gets the same profit. An incentive for goldplating or making unwise, but capital-intensive, investments is created.

Consider a simple example. Suppose Tom’s Telephone Co. needs paper for operations. The production, marketing, and accounting departments of Tom’s Telephone have separate printing and copy machines. A sharp manager at Tom’s recognizes that the company regularly orders separate paper shipments for each department, although the company could get a lower price through bulk ordering. Tom’s Telephone would spend less for paper, and the total cost of providing telephone service would be lowered if bulk ordering were utilized.

However, in a rate-of-return regulatory regime, the people at Tom’s Telephone would have little reason to implement the needed changes. Why should they? They would receive no benefit since the company can keep none of the savings.

Of course, these perverse incentives apply to more than just paper. From switching equipment to plush corporate office suites, and from fiber-optic cable to the compensation of executives, every spending decision is jaded by rate-of-return disincentives for thrift. Under rate-of-return, an investment in new decorations and artwork for Tom’s office earn the same return as an investment in infrastructure. A system that creates such incentives is contrary to common sense.

Alternative Models. The most common alternative to traditional rate-of-return regulation is known as “incentive regulation,” which usually takes the form of a price cap. Price cap regulation was first introduced in telecommunications markets in 1984 when it was applied to the newly privatized British Telecom. The idea quickly spread to America, and in June 1989 the Federal Communications Commission (FCC) instituted a price cap system for AT&T long-distance service. Then in 1990 the FCC adopted a price cap system for the interstate activities of local telephone companies.

At the same time, many state regulators were adopting new regulatory plans of their own.3 According to a CSE Foundation survey, nearly 35 states were using incentive-based systems as of 1995. By 1996, nearly half, 24, of the states were using price cap regulation and almost three of four (36 states in all) were using some form of incentive-based regulation.4

Price cap regulation works on a very simple principle. Price, or the cost to consumers, is regulated rather than profit. Here is how it works: initial price levels, or price caps, are set by the regulator in any of a variety of ways. They are often based on existing prices and revenues of the regulated company. These prices are either frozen or periodically adjusted. Adjustments would be based on an inflation index, and often a “productivity factor,” or X-factor. The X-factor is established by the regulator to reflect expected productivity improvements and innovations.5

Once the price caps are set, regulated firms can set prices equal to or below the cap. Firms retain all profits earned at this price. At the same time, any excessive spending comes out of their profits. This process harnesses the power of the profit motive to work for consumers. In order to generate profits, a local carrier must provide services at a cost below the regulated price. An incentive is created to introduce as many efficiencies and cost-saving measures as possible.6

Price caps are not a cure-all. If the caps are reviewed, the regulatory process offers the potential for political and not market forces to establish new caps. If an X-factor is adjusted too often, price cap regulation begins to resemble traditional rate-of-return regulation. There is also a danger of overestimating the rate of innovation. An X-factor that is set too high eventually forces prices too low – possibly below the cost of providing service.

Common objections to price cap regulation. Critics of price caps raise two primary objections. First, they say that it will allow companies to make excessive profits. Second, they argue that price caps encourage companies to cut costs by lowering the quality of service. Neither objection, however, stands up to close scrutiny.

1. “Excessive” profits. Despite what critics say, high profits are by no means assured under a price cap system. In fact, because no particular profit level is set, many firms – those who fail to become efficient – would actually make a lower profit than they would under a rate-of-return system.

Of course, for efficient and innovative companies, a higher profit may in fact be possible. But this is good news for consumers, not bad. The goal of regulation should be to protect consumers from bad service or unreasonable prices, not simply keeping companies from earning high profits. Remember that the profits of Microsoft made Bill Gates a billionaire at a time when prices for his software were plummeting.7

2. Service quality. Opponents of price caps also claim that it creates an undue incentive to slash service and quality in order to cut costs. While such a result is possible in theory, concerns could easily be addressed by establishing and enforcing strict quality standards. Adherence to standards can be monitored by relatively non-intrusive methods. Service blockages, the time of delay for a dial tone, and the response time to complaints can all be used to measure quality in an open and easily verifiable manner.

Initial studies from academia also suggest that the effects of price caps do not harm service quality and improve many measures of success. To cite one example, 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 under price cap regulation” and other incentive regulation than under rate-of-return regulation.

“The fraction of network lines served by modern switches is higher under” incentive regulation than rate-of-return regulation.

“Residential basic local service rates are lower under PCR [price cap regulation] than under RORR [rate-of-return regulation.]”

“There is no systematic link between incentive regulation and service quality, broadly defined.”8

Conclusion. State policymakers in Oregon and around the country are facing a number of crucial choices regarding the regulation of telecommunications. The first is whether to let markets (and consumers) determine prices and services, or to rely on regulation. Where competition exists, the market approach is better.

Where there is no competition, regulators still face important decisions as to how telecommunications services should be regulated. Under the traditional rate-of-return approach, the focus is on profits – ensuring a constant rate of return and automatically allowing companies to recover all their costs. The second alternative is to focus directly on the prices that consumers pay. The latter choice creates incentives for companies to be efficient, even if that means some make more (or less) than what regulators deem “appropriate.” For Oregon consumers, the choice is clear.

1For more information, see Wayne Leighton “The State of the States: A Consumer Report Card on Telecommunications Policy,” Citizens for a Sound Economy Foundation, Issue Analysis, March 16, 1995, and Wayne Leighton “Telecommunications Reform Bills: CFA Claims Just Don’t Ring True,” Citizens for a Sound Economy, Issue Analysis, No. 15, November 13, 1995.

2Section 3 (1) and Section 4 (1) of Senate Bill 142 of the 70th Oregon Legislative Assembly as introduced.

3Chunrong Ai and David E. M. Sappington, of the University of Florida at Gainesville, have examined the impact of state incentive regulation on network modernization, investment revenue, cost, profit, service quality, local service rates, and telephone penetration rates in the U.S. telecommunications industry between 1990 and 1996. See for instance, Ai and Sappington, “The Impact of State Incentive Regulation On the U.S. Telecommunications Industry” found at

4Ai and Sappington in Table 1 at

5Regulators also often review the base prices at regular intervals, often three to five years. At this time, regulators frequently re-adjust prices to costs. This can help keep prices in line with costs, but also reintroduces some of the perverse incentives of rate-of-return regulation to the system.

6For more detailed explanations of this incentive effect, see Shane Greenstein, Susan McMaster and Pablo Spiller, “The Effect of Incentive Regulation on Infrastructure Modernization: Local Exchange Companies’ Deployment of Digital Technology,” Journal of Economics and Management Strategy, Vol. 4, No. 2, 1995, and Alan Mathios and Robert Rogers, “The Impact of Alternative forms of State Regulation of AT&T on Direct Dial Long-Distance Telephone Rates,” The RAND Journal of Economics, Vol. 20, No. 3, 1989.

7See for example, Wayne Brough, “Microsoft and Monopoly,” Capitol Comment No. 217, CSE Foundation, December 14, 1998. For and extensive review, see also Richard B. McKenzie and William F. Shughart II, “Is Microsoft a Monopolist?” The Independent Review, vol. II, no. 2, (Fall 1998).

8Ai and Sappington.