ABSTRACT
This chapter describes an empirical methodology for studying the regulation of local telephone markets that combines an engineering process model of costs with models from the new regulatory economics. This technico-economic methodology is illustrated through the undertaking of two analyses. First, we study in some detail the properties of optimal regulation under asymmetric information. We examine three issues: (a) the extent of natural monopoly when informational rents associated with regulation are taken into account; (b) the extent of the divergence of pricing under the optimal regulatory mechanism from optimal pricing under complete information (incentive correction); and (c) the implementation of optimal regulation through a menu of linear contracts. We find that, for fixed territory, strong economies of scale allow local exchange telecommunications to retain monopoly characteristics even when the (informational) costs of regulation are properly accounted for. Furthermore, the incentive correction term is small in magnitude, and optimal regulation can be well approximated through relatively simple linear contracts. In the second phase of our analysis, we evaluate the relative performance of various regulatory mechanisms, from both traditional and modern (incentive) points of view. This analysis allows us to quantitatively assess the social value of regulatory transfers and of good cost auditing procedures, the redistributive consequences of the various forms of regulation, and the sensitivity of the relative performance of the various methods of regulation to the cost of public funds.
