Quality & Quantity 37: 169–191, 2003.
© 2003 Kluwer Academic Publishers. Printed in the Netherlands.
The Effect of Incentive Regulation in
Telecommunications in the United States
NOEL D. URI
Pricing Policy Division, Wire Line Competition Bureau, Federal Communications Commission,
Washington, DC, U.S.A.
Abstract. Incentive regulation is now an important regulatory tool in the telecommunications in-
dustry in the United States. The issue explored here is whether incentive regulation has resulted in
an increase in productive efﬁciency. After providing an overview of the nature of incentive regula-
tion, one methodology for measuring the effects of incentive regulation on productive efﬁciency is
reviewed. This methodology is data envelopment analysis (DEA) and allows for the measurement
of both scale efﬁciency and technical efﬁciency of individual local exchange carriers. The results
indicate that most local exchange carriers were technically efﬁcient over the 1988–1998 period. Four
LECs, however, consistently demonstrate scale inefﬁciency. In the aggregate, however, based on the
DEA results there was no identiﬁable improvement in aggregate LECs’ technical efﬁciency between
1988 and 1998. Subsequently, an alternative methodology, a stochastic frontier production function
approach, is considered. The results from this methodology conﬁrm that there was no change in
technical efﬁciency over the period of study, something that incentive regulation was speciﬁcally
designed to enhance.
Key words: Data envelop analysis, incentive regulation, local exchange carrier, technical efﬁciency
Incentive regulation has become an important regulatory tool in the telecommu-
nications industry in the United States. The basic structure of incentive regulation
as it has most commonly been adopted in the telecommunications industry in the
United States is in the form of price caps. The issue that will be explored below is
whether de facto price caps have resulted in an increase in productive efﬁciency.
Before exploring this issue, however, some background is needed.
For several decades, there has been substantial criticism of rate-of-return regu-
lation. From the initial formal analysis by Averch and Johnson (1962), concerns
have centered around the potential for inefﬁciencies. It was suggested that a proﬁt-
The views expressed are those of the author and do not necessarily represent the policies of the
Federal Communications Commission or the views of other Federal Communications staff members.