Review of Industrial Organization 16: 343–356, 2000.
© 2000 Kluwer Academic Publishers. Printed in the Netherlands.
The Political Economy of Price Cap Regulation
DALE E. LEHMAN
Department of Economics, Fort Lewis College, Durango, CO 81301, U.S.A.
DENNIS L. WEISMAN
Department of Economics, Kansas State University, Manhattan, KS 66506, U.S.A.
Abstract. The last decade has witnessed a dramatic substitution of price cap regulation for rate-of-
return regulation in the telecommunications industry. The 1996 Telecommunications Act empowers
state regulators to set the terms of competitive entry in local telephone markets. We investigate
whether the form of regulation endogenously affects the regulator’s behavior with respect to com-
petitive entry. The evidence reveals that regulators in price cap jurisdictions tend to set more liberal
terms of entry in comparison with regulators in rate-of-return jurisdictions. This suggests that price
cap regulation suffers from incomplete contracting, undermining the potentially superior incentive
properties of this important regulatory reform.
Key words: Price caps, regulation, Telecommunications Act.
The widespread adoption of price cap regulation, both in the United States and
abroad, is arguably one of the crowning achievements of regulatory economics this
century. In a little more than a decade, more than 30 states in the U.S. have adopted
some form of incentive regulation for local telephone service providers, with price
cap regulation being the predominant form. A similar transition is underway in
the electric power and natural gas industries. In the world of government regula-
tion, this is nothing short of warp speed. No doubt numerous arguments could be
advanced to explain this phenomenon, but none more compelling than the simple
reality that price cap regulation seemingly offered something for everyone.
In replacing traditional rate-of-return (ROR) regulation with price cap regu-
regulators were able to put in place a form of regulation with incentive
The authors thank Barbara Cherry, Alfred Kahn, William Kovacic, David Sappington, Timothy
Tardiff, and participants in the Rutgers 11th Annual Western Conference of the Advanced Workshop
In Regulation and Competition for constructive comments on earlier drafts of this paper. The authors
also acknowledge the constructive comments of the General Editor and two anonymous referees that
led to substantive revisions. The usual caveat applies.
Price cap regulation is a subset of the general class of incentive regulation regimes that also
includes banded ROR regulation, rate moratoria and revenue sharing. See Sappington and Weisman