SUPERIOR REGULATORY REGIMES IN THEORY AND PRACTICE

A substantial body of recent research finds that price-cap regulation is superior to cost-based regulation in that many of the distortions associated with the latter are reduced or eliminated entirely. We prove that the hybrid application of cost-based and price-cap regulation that characterizes current regulatory practice in the United States telecommunications industry may generate qualitative distortions greater in magnitude than those realized under cost-based regulation. It follows that price-based regulation in practice may be welfare-inferior to cast-based regulation. The analysis further reveals that the firm subject to this modified form of price-based regulation may have incentives to engage in pure waste.