Information, Incentives, and Commitment in Regulatory Mechanisms: Regulatory Innovation in Telecommunications

The incentive theory of regulation has generally been developed in the context of monopoly regulation or of supply by a publicly owned firm and thus is most applicable to state regulation of local telephone companies.1 Although this theory may not be directly applicable to those segments of the telecommunications industry that are, or soon will be, sufficiently competitive that regulation will not be needed, the principles identified may be applicable to the transition period from regulation to competition. The theory presented here thus is viewed as pertaining to the transition to competition and to the regulation of local telephone service which, in spite of the alternative of cellular and cable systems, is likely to remain regulated for the foreseeable future. The article thus focuses on cost-based pricing policies and the associated incentive problems with particular emphasis on longterm policies that respond to information that is generated through performance in earlier periods. The regulatory mechanisms considered are in the spirit of recent policy proposals to delegate to the firm the authority to make certain decisions subject only to caps on profits or prices. The mechanisms prescribe a set of implementable policies and delegate to the firm the choice of a particular policy based on the information it has about its costs. The policies cover extended periods of time, so they may include provisions that allow prices to adapt to information revealed by either exogenous events or performance in earlier periods.