FTC Staff Comment Before the Illinois Commerce Commission In the Matter of The Blue Ribbon Telecommunications Task Force Outline of Purpose and Request for Assistance

.~ .-
I
BEFORE THE
ILLINOIS COMMERCE COMMISSION
SPRINGFIELD, ILLINOIS 62794
October 19, 1990
COMMISSION AUTHORIZED
'V CZ d 0 () C{5-
10 The Matter of
The Blue RlbboD TelecommuDicatloDs
Task Force OutllDe of Purpose aDd
Request for AsslstaDce
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Comments of the Staff
of the Bureau of Economics and the Chicaeo Regional Office
of the Federal Trade Commlssion l
I. Introduction
The staff of the Federal Trade Commission (FTC) appreciates this opportunity to
submit a response to the Blue Ribbon Telecommunications Task Force's request for comment
on Illinois's regulation of intrastate telecommunication services. The Task Force is attempting
to determine what form of regulation is most appropriate for intrastate telephone services
when the current provisions governing this area expire in December of 1991.
The current regulatory structure is the result of a study of telecommunications in
Illinois that the Illinois Commerce Commission participated in during 1984 and 1985. 	This
study led to the passage of Article 13 of the Illinois Public Utilities Act, which for the first
time granted pricing flexibility to providers of telecommunications services classified as
"competitive" and also facilitated entry into some telecommunications markets.
Article 13 expires December 31, 1991. Consequently, the Illinois Commerce Commission
is again examining the telecommunications market in Illinois and has created a Blue Ribbon
Task Force to assist in the analysis of the benefits enjoyed by Illinois consumers because of
Article 13. 	The Task Force has requested comments on a number of issues, including what
1 	This comment represents the views of the staff of the Bureau of Economics and the
Chicago Regional Office of the Federal Trade Commission. They are not necessarily the views
of the Commission or any individual Commissioner. Inquiries regarding the comment should
be directed to Alan D. Mathios (202-326-3495) of the FTC's Bureau of Economics.

form of telecommunications regulation should be adopted after Article 13 expires. The Task
Force has thus requested comments on whether the Illinois Commerce Commission should: (I)
be required to regulate earnings directly (rate-of -return regulation), (2) grant some measure
of earnings flexibility to firms, and (3) regulate telecommunications carriers by capping prices
directly (price-cap regulation), without monitoring earnings levels. Our analysis of economic
theory and the empirical evidence indicate that price-cap regulation may be preferable to
rate-of -return regulation for certain telecommunications services. Our analysis also concludes
that policies that facilitate entry into certain telecommunications markets are likely to result
in lower prices to consumers.
After briefly discussing the background of state regulation of telecommunications
services our comments summarize the theoretical advantages and disadvantages of price-cap
regulation compared with rate-of -return regulation of telecommunications services. 	The
economic literature indicates that firms are likely to have greater incentives to minimize cost
under price-cap .egulation than under rate-of-return regulation. 	Lower costs, in turn, might
lead to lower prices to consumers under price-cap regulation. 	However, the theoretical
evidence in favor of price-cap regulation is not unequivocal. 	Consequently, Section IV then
examines the empirical evidence concerning actual prices for telecommunication services
under the various forms of regulation. 	This evidence indicates that, on average, prices for
intrastate interLATA 2 long distance toll service are already lower in states that have adopted
price-cap regulation. s
2 	InterLATA service is a type of long distance service. 	Many states, such as Illinois,
contain a number of Local Access and Transport Areas (LAT As). 	A LATA can cover several
area codes. 	Interstate interLA T A service is governed by the FCC. 	Intrastate service, both
intra and interLA T A, is regulated by the Illinois Commerce Commission. 	Long distance
companies such as AT&T, MCI and Sprint, etc. provide 	interLATA service. 	The local
telephone companies (such as Illinois Bell) are not permitted to provide long distance service
between LAT As, but do provide this service within a LATA. 	Illinois is divided into "Market
Service Areas" or "MSA's" which are functionally equivalent to LATAs.
S 	The comparison of prices across regulatory regimes was examined using statistical
techniques (multivariate regression) that account for a variety of factors that might effect
the price of long distance service. 	For example, the study controlled for differences across
states in population density, wages of telecommunication workers, income, the number of
providers of interLA T A long distance service in the state etc.
2

It should be noted that intrastate interLATA long distance service has been subject to
increasing levels of competition. 	Consequently, the empirical work currently available does
not address how price-cap regulation compares with rate-of -return regulation,for services such
as residential local exchange service, which have little or no competition. 	Our comments do
examine the theoretical implications of applying price-cap regulation to services that more
closely fit the natural monopoly paradigm. 	While the theoretical advantages of price-cap
regulation (relative to rate-of -return regulation) apply regardless of the market structure of
the regulated service, there is a greater possibility that a monopolist, after experiencing cost
reductions that could arise under both types of regulation (e.g., input prices decline), would
pass such cost reductions on to consumers as lower prices under rate-of -return regulation. In
light of this possibility, our comment outlines several adaptations to a price-cap regulatory
framework that are intended to preserve cost minimization incentives, while providing some
additional safeguards to consumers.
Third, and finally, our comment analyzes the impact of entry regulation on the prices
of telecommunications services. 	Article 13 permits more than one carrier to provide various
telecommunications services. 	Empirical evidence indicates that consumers in markets with
more than one carrier providing intrastate intraLA TA long distance service are charged
significantly lower prices than consumers in other markets.
II. 	Expertise of the Starr of the Federal Trade Commission
The FTC is an independent regulatory agency respor.sible for maintaining competition
and safeguarding the interests of consumers. 	In response to requests by federal, state, local
governments, and others, the staff of the FTC often analyze regulatory or legislative proposals
that may affect competition or the efficiency of the economy.
The staff have recently examined price and entry regulation in the telecommunications
and 	cable 	TV 	markets. 	For 	example, 	staff 	have 	analyzed 	the 	prices 	of 	intrastate
3

· .
telecommunications services under alternative forms of regulation.· 	Moreover, in a recent
comment to the FCC concerning the regulation of cable television rates, the staff of the
Bureau of Economics and the San Francisco Regional Office analyzed the potential benefits
of price-cap regulation compared to rate-of-return regulation. s The staff of the Bureau of
Economics have examined the impact of entry regulation on intrastate telephone rates. 6
III. 	Backeround on State Reeulatlon of Telecommunication Services
A. Introduction
Prior to the early 1970s, AT&T and its affiliated Bell Operating Companies (BOCs --
the local exchange arms of AT&T) provided virtually all long distance telecommunications
services in the United States, and was the dominant supplier of other telecommunications
services.1 	With the permission and encouragement of the FCC and the state Public Utility
Commissions (PUCs), AT&T set the prices of interstate and intrastate long distance service
above cost respectively, in order to subsidize local exchange service. 	However, beginning in
the 1970s, the FCC adopted policies that encouraged the development of cost-based prices and
that supported increased competition in the provision of interstate long distance services. 8
4 See, Mathios A. and R.P. Rogers, "The Impact of State Price and Entry Regulation on
Intrastate Long Distance Telephone Prices," Staff Report to the Federal Trade Commission,
November 1988, and Mathios, A. and R.P. Rogers, "The Impact of Alternative Forms of State
Regulation on Direct Dial Intrastate Telephone Rates," RA.ND Journal of Economics, Vol. 20,
No.3 (1989). 	A copy of the staff report is attached.
6 See Comments of the Staff of the Bureau of Economics and the San Francisco Regional
Office of the Federal Trade Commission In the Maller of Competition, Rate Deregulation and
the Commission's Policies Relating to the Provision of Cable Television Service, MM Docket No.
89-600, April 20, 1990.
6 See, Mathios A. and R. Rogers (1988) supra note 4 and, Mathios, A. and R. Rogers, "The
Impact and Politics of Entry Regulation on Intrastate Telephone Rates," Journal of Regulatory
Economics, Vol. 2 (1990).
1 Though the BOCs provided a majority of local exchange service, there were other local
exchange companies that primarily served rural areas.
8 The subsidy of local exchange service by interstate and intrastate long distance service
was accomplished 	via 	a cost and 	revenue allocation 	mechanism called separations and
settlements, 	respectively. 	The 	introduction of competition and changes in 	the 	revenue
allocation mechanism were both responsible for the movement towards cost-based pricing. For
a 	detailed description of the separations and settlement mechanism see 	Noll 	R., "State
4

New entrants and regulators, however, began to Question 	whether AT&T 	was using its
dominant position in the telecommunications market to inhibit these developments.
Competitors and 	the 	Department of Justice (DOJ) alleged 	that 	AT&T .- via 	its
ownership and control of the local BOCs .- frustrated the growth of long distance competition
by providing its rivals with inferior access to local exchange customers or by denying access
altogether. 	In a 1982 settlement of an antitrust complaint filed by the DOJ (known as the
Modified Final Judgement [MFJ]) AT&T agreed to divest the BOCs." 	Once the BOCs were
independent, their incentive, if any, to discriminate against AT&T's long distance competitors
in providing the latter local exchange access was eliminated. 	Since the entry of the MFJ,
competition 	in 	interstate 	telecommunication services 	has 	developed 	rapidly. 	Increased
competition in long distance services (and partial abandonment of the subsidization of local
telephone service) led many states to reexamine the regulation of intrastate services.
B. Intrastate InterLATA Senlces
Following the emergence of competition for interstate long distance services, Illinois
and almost all other states permitted competition in the provision of intrastate interLATA long
distance service. 10 	After the AT&T divestiture, most of the 39 states with more than one
LATA (including Illinois) based their regulation of intrastate interLA TA service on the
distinction between dominant and nondomiIiant firms. Typically, the dominant firm (AT&T)
was subject to strict rate-of -return regulation, while nondominant firms (other competitors)
Regulatory Responses to Competition and Divestiture in the Telecommunications Industry,"
in Antitrust and Regulation by Greison, R., Heath and Co. (1986).
g See U.S. v. AT&T, 552 F. Supp. 131 (D.D.C. 1982). Among other limitations, the terms of
the MFJ define the lines of business that the BOes may and may not enter. 	Under the terms
of the MFJ the BOC's can only provide local and long distance intraLA T A service. 	Because
almost all intraLA TA service is intrastate it is governed by state regulatory commissions. In
some states (not including Illinois) only the BOC is allowed to provide intraLA T A long
distance service.
10 	Under the MFJ states could prohibit competition for intrastate services.
5

were subject to minimal regulation.H Under rate-of-return regulation, the dominant firm must
undergo more extensive procedures to raise or lower price.
More recently, many states (including Illinois under Article 13) have been exploring
different regulatory approaches for determining the permissible rates that dominant firms
such as AT&T can charge for intrastate interLA T A toll services. Several different forms of
regulation have been employed. 	Some states allow dominant firms unconstrained pricing
flexibility, others set maximum prices, and still others set both minimum and maximum
prices.12 	A 1987 survey of state regulation policies indicates that between 1984 and 1987, 28
of the 39 multiLA TA states relaxed their regulation of AT&T's intrastate interLA TA service. IS
As noted, Illinois is one of the states that has departed from rate-of-return regulation
in dealing with this type of service. 	When Illinois interLA T A long distance service is
"competitive" under Article 13 14 there is no rate-of -return regulation and no maximum price
limitations that can be charged. 15
11 	AT&T is considered dominant because following the divestiture, AT&T already had
large shares of intrastate long distance markets.
12 In 1989, the FCC adopted a price cap regulatory framework in place of traditional rate-
of-return regulation for AT&T interstate interLATA long distance service, and for other
business services. For the history of the development of thc transition to pricc cap rcgulation
see Policy and Rules Concerning Rates lor Dominant Carriers. Notice 01 Proposed Ru/emaking, 2
FCC Rcd 5208 (1987), Policy and Rules Concerning Rates lor Dominant Carriers, Further Notice
01 Proposed Rulemaking, 3 FCC Rcd 3195 (1988), and 	Policy and Rules Concerning Rates lor
Dominant Carriers, Report and Order and Second Further Notice 01 Proposed Rulemaking, 4 FCC
Rcd 2873 (1989).
13 See "How States Have Relaxed Rcgulation of AT&T Intrastatc Scrvices," State Telephone
Regulation Report, 	Vol. 5, No. 12, June 18, 1987. Thesc survey results were incorporated into
the empirical work conducted by the staff of the FTC, which is discussed in Section IV(B) of
this comment.
14 Section 13-502 states" A service shall bc classified as competitive only if, and only to
the extent that, for some identifiable class or group of customers in any exchange, group of
exchanges, or some other clearly defined geographical area, such scrvicc, or its functional
equivalent, or a substitute service, is reasonably available from more than one provider,
whether or not any such provider is a telecommunications carrier subject to regulation under
this Act."
15 	Section 13-504 states the conditions for proposed changes in price for interexchange
(interLA T A) services classified as competitive. Section 13-504, p. 307 states:
(a) any proposed decrease in rates or charges, or proposed change in any classification
or tariff resulting in a decrease in rates or charges, for competitive local exchange or
6

C. latraState latraLA T A Services
Within each LATA there are both local and long distance services offered. 	We deal
with each of these in turn.
1. [nl,aLATA Long D;slllllCe Sen;ce
Many states approach the regulation of interLA TA and intraLA TA services differently.
As noted above, in many states the initial efforts to deregulate were limited to allowing
competition only at the intrastate interLA T A level. 	In 1986, for example, only 14 states
allowed carriers such as AT&T, MCI, and Sprint to compete with the BOCs for intrastate
intraLATA long distance service. 	The trend, however, has been towards more competition.
A recent survey indicates that in 1989, 32 states allowed some degree of facilities-based
competition. 1S Forty-two states permitted resale of intraLA T A toll service. 17
interexchange telecommunications service shall be permitted upon the filing of the
proposed rate, charge, classification or tariff.
(b) any proposed increase in rates or charges, or proposed change in any classification •
or tariff resulting in an increase in rates or charges, for a competitive interexchange
telecommunications service shall be permitted only upon the filing of the proposed rate,
charge, classification or tariff and upon notice to all potentially affected customers
through a notice in each such customer's bill prior to the date of implementation of
such increase or change, or where such customers are not billed, by an equivalent means
of prior notice.
16 Companies like AT&T, MCI and Sprint are known as facilities-based carriers because
they own their transmission facilities. 	Other types of carriers, often called resellers, lease
transmission 	capacity 	from 	facilities-based 	carriers 	and 	use 	this 	capacity 	to 	offer
telecommunications services.
17 See "Intra-LATA Toll Competition Authorized in Most Western States (Part Two of a
Two-Part Series), State Telephone Regulation Report, Vol 7. No.8, May 4, 1989. In many states
that restrict facilities-based carriers from entering the intraLA T A market, rescUers can lease
capacity from these carriers and resell it in areas where the facilities-based carrier is barred
from providing service. 	Thus. even though facilities-based competitors may not provide
intraLA T A service directly, they may be able to do so indirectly via reseUers.
7

Article 13 allowed facilities-based competition for intraLA TA long distance service to
occur after January 1, 1987. 18 Prior to and after this date, resellers were permitted to provide
intra LA TA long distance service, and these resellers were largely unregulated. 19
2. 	Local Exchange and Other Services
Most states use rate-of -return regulation for basic local exchange service.2o This is also
true in Illinois because basic local exchange service does not qualify as "competitive" under
Article 13. 	However, other local services, such as Centrex, 900 service, and billing and
collection services l.[£ classified as competitive, and thus can be priced more flexibly under
Illinois law.21
D. 	Conclusion
States vary in their treatment of the regulation of telecommunication services. 	This
variation has allowed researchers to examine empirically the relationship between various
forms of regulation and consumer prices. 	The remainder of our comment focuses on the
comparison of these alternative approaches from both a theoretical and empirical viewpoint. 22
IV. 	Price-Caps Versus Rate-or-Return Reaulation
A. Tbeory
The PUCs, such as the Illinois Commerce Commission, have traditionally used rate-of-
return regulation to determine the price of various telecommunication services. 	There are
18 Section 13-403.
19 Resellers often provide service in areas where facilities-based providers are prohibited.
If prohibitions on facilities-based carriers are removed, some resellers might be replaced by
the facilities-based carrier. However, in many states both resellers and facilities-based carriers
provide service in the same market.
20 	The FCC replaced traditional rate-of -return regulation with price cap regulation for
the access fees charged to the interexchange companies by the local exchange company. 	For
a detailed discussion of the development of this order, see 4 FCC Red 2873 (1989).
21 	Section 13-505 allows for some pricing flexibility for "competitive" local exchange
services.
22 Our analysis of empirical work is limited to intraLA T A and interLA T A long distance
services. 	However, we examine the theoretical implications of permitting pricing flexibility
f or local exchange serv ices.
8

• r
theoretical advantages and drawbacks in departing from rate-of-return regulation. The goal
of rate-of-return regulation is to exploit the advantages of natural monopoly (e.g., scale
economies), while requiring the monopolist to pass on the benefits of these technological
advantages to consumers of the product. 	Rate-of-return regulation requires the regulator to
estimate the cost and demand conditions facing the monopolist, and to set a price (or set of
prices) that just permits the firm to cover its cost, including a competitive return on capital.
The potential difficulties associated with this form of regulation are many and well
documented.23 First, the regulator requires an enormous amount of information to carry out
its task and generally must rely upon the regulated monopolist to supply a substantial portion
of this information. 	This regulatory process can be administratively costly and subject to
possible manipulation on the part of the regulated entity. 	Second, rate-of-return regulation
can lead to systematic biases in capital investment by the regulated firm. 	Third, rate-of-
return regulation provides the firm with little incentive to reduce cost, because the cost
reductions are subject by the PUCs to being fully rebated to customers. 24 	Fourth. if the
regulated entity also sells in unregulated markets, the opportunity for profitable. yet socially
inefficient, cross-subsidization is created.26
The existence of these problems has induced a search for alternative regulatory
mechanisms that might offer promise of superior performance. Price-cap regulation is. in our
view, a very promising alternative. Price-cap regulation can be characterized as follows: 2e (1)
the regula tor sets a price ceiling, but. in contrast to rate-of -return regulation. the firm has
discretion, without regulatory review. to set its prices below this ceiling; (2) the price ceiling
is periodically adjusted automatically by a factor that is exogenous to the firm (e.g .• an
23 	See Brennan, T., "Regulation by Capping Prices." Journal of Regulatory Economics
(1989), and the sources cited therein.
24 See Mathios and Rogers (1989) supra note 4. and the references cited therein.
26 See Brennan, T., "Cross-Subsidization and Discrimination by Regulated Monopolists,"
U.S. Department of Justice Economic Analysis Group Working Paper No. EAG 87-2, 1987.
26 See Acton J.P., and I. Vogelsang, "Symposium on Price-Cap Regulation: Introduction,"
RAND Journal of Economics (1989).
9

adjustment to reflect overall inflation); and (3) over longer intervals, the ceiling and automatic
adjustment factor are subject to review and possible revision.
Proponents of price-cap regulation have made a number of claims on its behalf. First,
because firms are allowed to retain a portion of their cost reductions, they may have a greater
incentive to reduce costs than under rate-of-return regulation.27 Consumers would benefit
from this if price-cap regulation causes some portion of anticipated cost decreases to be passed
on to consumers through lower prices. 	The fact that price can be reduced without prior
regulatory review provides an inducement (relative to rate-of-return regulation) to cut price
when costs fall. 28 	Moreover, a firm may be more willing to lower prices under a price-cap
regulatory approach because proposed price decreases cannot be contested by competitors and
subsequent price increases cannot be denied if the price stays below the ceiling.2Q Under rate-
of -return regulation, a firm knows that future price increases must be approved by the PUC.
Consequently, firms 	may 	hesitate 	to lower prices since future 	increases 	involve costly
administrative proceedings and politically unpopular price increases may be denied.
In addition, the administrative costs of price-cap regulation are likely to be lower than
those 	associated 	with 	rate-of -return regulation, since there is less regulatory oversigh t.
Further, the regulator's informational burden is probably lower than under a rate-of-return
regime. Price-cap regulation may also make it easier to develop mechanisms that provide the
27 	See Cabral L., and M 	Riordan, "Incentives for Cost Reduction Under Price Cap
Regulation," Journal of Regulatory Economics 1 (1989).
28 Regulatory review of price reductions is costly and time-consuming. Moreover, in the
case where there is more than a ~ngle firm providing the service, regulatory review affords
less efficient rivals an opportunity to prevent or delay the price cut if, as is typically the case,
they have standing to participate in these proceedings. It has been noted that AT&T's rivals
opposed virtually every price reduction proposed by AT&T since its 1982 divestiture, and some
of these rivals may have been less efficient than AT&T. 	See, for example, Haring J. and E.
K werel, "Competition Policy in the Post Equal-Access 	Market," FCC, OPP Working Paper
Series, No. 22, 1987.
2Q See Hayes B. and D. Seigel, "Rate of Return Regulation With Price Flexibility," Journal
of Business, Vol. 59 (1986).
10

firm with an incentive to reveal cost and demand information truthfully to the regulator.3o
Moreover, price-cap regulation may substantially curtail the ability and incentive of firms
to engage in cross-subsidization. 31 	Since there is a cap on prices, firms are limited in their
ability to enhance profits by shifting costs from more competitive unregulated services to less
competitive regulated activities. 	Furthermore, since reductions in cost are not necessarily
rebated to consumers, the incentive to shift costs from one service to the other is largely
eliminated.
Though powerful, the theoretical arguments in favor of price-cap regulation are not
unequivocal. 	Some have argued on theoretical grounds that the supposed benefits of price-
cap regulation will not materialize under some conditions.s2 For example, some question the
ability of the PUC credibly to commit to permitting the r~gulated firm to earn supranormal
profits for significant periods of time, in which case the firm's incentive to minimize costs are
diminished. Additionally, firms may have the incentive under price-cap regulation to reduce
quality since the firm retains the cost reductions from this activity. Moreover, reductions in
costs that are not due to the increased incentives to minimize costs under the price-cap
regulatory framework and which are unanticipated when the price ceiling is determined may
result in higher prices to consumers than would have been the case under rate-of -return
regulation." 	Under rate-of-return regulation, these "exogenous" cost reductions would be
so See Sibley, D., "Asymmetric Information, Incentives, and Price-Cap Regulation," RAND
Journal of Economics, Vol 20, No.3, (1989). 	Sibley's model requires only that the regulator
audit the firm's profits from sales and lagged profits in order to design a pricing scheme that
is similar to price-cap regulation. Under this pricing scheme the firm has incentive to reveal
truthfully demand and cost information.
SI 	For a detailed analysis of the incentives firms face to misrepresent costs, and to
diversify into competitive markets under alternative regulatory regimes see Braeutigam R.R.,
and J.e. Panzar, "Diversification Incentives Under "Price-Based" and "Cost-Based" Regulation."
RAND Journal of Economics, Vol. 20, No.3, (1989).
32 	See Brennan (1989) supra note 23 and Schmalensee R., "Good Regulatory Regimes,"
RAND Journal of Economics, Vol. 20, No.3, (1989).
33 See Cabral and Riordan (1989) supra note 27 for a discussion of the potential for prices
under price cap regulation to be higher than under rate-of-return regulation.
11

reflected in a lower rate base and therefore lower prices.~ However, there are additional
safeguards that can be implemented that would help insure that consumers share in the gains
from these cost declines. For example, many states that permit pricing flexibility also monitor
earnings and establish formulae attempting to ensure that any excess profits are shared with
consumers. 35 	While this diminishes, somewhat, the incentives for firms to engage in cost
minimizing strategies, the incentives remain because firms are permitted to retain some of the
earnings resulting from cost reductions. 	We discuss this in more detail in Section V of the
comment.
B. 	Empirical Evidence
There is limited empirical evidence comparing prices of regulated services under
alternative regulatory regimes. To our knowledge, the only major empirical study that directly
compares prices under rate-of -return regulation and price-cap regulation is that of Mathios
and Rogers (1989).36 	They compare AT&T rates for intrastate interLATA long-distance
telephone service in states that allow pricing flexibility with AT&T's rates in states that use
rate-of-return regulation. 	However, since interLATA long distance service is subject to
increasing levels of competition, the study does not address how prices compare across
regulatory regimes for services that more closely fit the natural monopoly paradigm, such as
residential local exchange service.51
The findings sugge~t that AT&T's daytime, evening, nighttime, and weekend rates were
significantly lower in states that allowed pricing flexibility than in states that used rate-of-
return regulation. For example, the cost of a five minute call during the day is approximately
7 percent lower in states that have allowed some form of pricing flexibility.
34 This argument does not apply to cost reductions that are motivated by 	the enhanced
incentives to reduce costs under price-cap regulation.
35 See various issues of State Telephone Regulation Report (1987, 1988, 1989).
36 See Mathios and Rogers (1989) supra note 4, and Mathios and Rogers (1988) supra note
4.
37 However, the study did control for the number of carriers providing interLATA long
distance service in each state. 	Controlling for this variable did not change the conclusions
regarding price-cap regula tion compared wi th ra te-of -return regula tion.
12

The study also examines how rates vary across different types of pricing flexibility.
Some states have allowed AT&T to change prices within a specified band or to change a price
as long as it stays below a specified maximum price without any formal review. 	Other states
have permitted AT&T full pricing flexibility. but in many of these states the PUC retains
the right to review (though not through formal rate cases) prices set by AT&T and prevent
AT&T from implementing those deemed unfair or unreasonable. 	Consequently. it may be
difficult to ascertain the true degree of pricing flexibility that AT&T has in these states.38
The empirical results indicate that consumers in states that allow AT&T to set prices
within a specified band or below a specified maximum pay approximately 14 percent less for
comparable services than consumers in states that allow no pricing flexibility. States allowing
AT&T full pricing flexibility (subject to review) have prices that are only 1 percent lower
than prices in states without pricing flexibility.s~
It is unclear why prices are lower in states that establish price bands or maximum
prices than in states that appear to allow more flexibility. 	One possible explanation is that
AT&T actually has less incentive to lower prices in states with full pricing flexibility, since
these states still retain the right to review and prevent AT&T price changes. 	By contrast.
when a band or maximum is established. all price changes within the band or below the
maximum are free of potential regulatory review. Another possible explanation is that AT&T
is free to raise prices in states with pricing flexibility. but is constrained from doing so in
states that set maximum prices. However, this explanation appears unlikely because in many
states with maximum or banded price regulation, AT&T prices are below the legislated ceiling.
While the study of alternative regulatory regimes did not examine quality. there has
been no empirical evidence documenting quality differences across regulatory regimes. This
is not surprising. 	AT&T is unlikely to allow service quality to decline when it must compete
with other long distance service providers.
38 Through 1987. only Montana and Nebraska have actually taken steps to exempt AT&T
from state regulation. 	See State Regulation Telephone Report (1987) supra note 13.
s~ The price comparisons in the study of alternative regulatory regimes did not examine
quality. 	We have assumed there were no material quality differences across states.
13

V. 	Conclusions from the Theory and Evidence
This section attempts to apply the discussion of the theory and empirical evidence in
Section III to specific types of telecommunication services in Illinois.
A. 	Application to Intrastate InterLAT A LODe Distance Service
We believe that the theoretical and empirical work discussed above provides a strong
basis for considering price-cap regulation for intrastate interLATA long distance service in
Illinois. 	This regulation preserves the cost-reducing incentives of AT&T while retaining
safeguards for consumers in the form of price ceilings. 	Moreover, the increasing level of
competition in the Illinois intrastate interLA TA market provides additional safeguards to
consumers. If exogenous industry-wide cost reductions arise that are not reflected in the price
ceiling, competition may cause these cost reductions to be transferred to consumers. 	This
increased level of competition"O may explain why, in several states, AT&T has priced its
intrastate interLA TA long distance service below the legislated ceiling. 	This also appears to
be true for AT&T's business services. As of July 1989, the Price Cap Index for AT&T's Basket
3 services (business services) was 99.5, while the Actual Price Index for Basket 3 services was
94.3. 41 This increased level of competition may also limit the ability of AT&T to lower service
quality, as we are unaware of any evidence suggesting that quality differs across states with
alternative regulatory frameworks.
40 	Although we have not conducted a market by market study, some sense of the extent
of competition in interLA T A toll service markets is provided by statistics revealing the large
number of present competitors, many of whom are recent entrants. For example, the FCC has
reported that by March 1987, over 219 carriers purchased equal access to the local telephone
network. 	MCI and AT&T purchased equal access in all states, and Sprint purchased equal
access in 47 of the 48 states surveyed. 	Five other carriers served 25 or more states and 19
served four or more. 	More recen t reports indica te that by 1990 at least 25 in terexcha nge
carriers have purchased equal access in Illinois. 	Including resellers, Illinois has over 100
interexchange companies providing service. 	For a more in-depth discussion of the increased
level of competition in the InterLA T A market see the FCC notice of proposed rulemaking
Competition in the Interstate Interexchange Market Place Docket No. 90-132, and Trends in
Telephone Service, Industry Analysis Division, Common Carrier Bureau, FCC, February 14,
1990.
41 	See FCC Docket No. 90-132 at p. 28.
14

B. 	Price-Cap ReaulatioD for Other Services
The increased level of competition that exists in Illinois intrastate interLA TA long
distance service reduces the need for stringent rate-of -return regulation. 	However, many
telecommunication services are not subject to the level of competition that exists for Illinois
interLAT A long distance service. 	For example, residential local exchange service remains
largely dominated by Illinois Bell. Should price cap regulation be applied to services that are
subject to limited or no competition? 	Based on the theoretical discussion that follows we
conclude that price-caps should be applied to services that are subject to limited or no
competition.42 	However, the Illinois Commerce Commission may wish to adopt additional
consumer safeguards to ensure that consumers share in any cost reductions experienced by the
firm.
1. 	Cosl Reduclions Tluzl Occur Because of Price-Cap Regulalion
The theoretical advantages of price-cap regulation apply regardless of the market
structure in which the firm operates. Consider a monopolist providing local exchange service.
Price-cap regulation provides the monopolist the incentive to minimize costs to obtain short
term excess earnings. 4 :S However, consumers can also gain from these cost reductions because
a monopolist faced with a downward shift in its marginal cost curve has an incentive to lower
its output price. Under price-cap regulation, the degree to which cost reductions are reflected
in price reductions depends on the level of the price ceiling.
Figure 1 illustrates the effect of a decrease in marginal cost on the monopolist's output
price under price-cap regulatio:1. 	Consider an unconstrained monopolist facing a demand
curve D, and a marginal cost curve MC I . 	The profit maximizing monopolist will produce
output to the point where marginal cost equals marginal revenue, QI. The price to consumers
is determined by the height of the demand curve at QI' given by Pl. 	If price cap regulation
induces lower costs, the marginal cost curve will shift downward to, say, MC 2• 	In the new
42 	As noted 	previously, the empirical evidence discussed in this comment does not
necessarily apply to services that are subject to limited or no competition.
43 	By short term excess profits we mean earnings above the normal rate of return on
investment.
15

equilibrium, 	marginal 	cost 	intersects
marginal 	revenue 	at 	Q, 	and 	the 	new
equilibrium price falls to P,. 	Under price-
cap regulation, however, the monopolist is
constrained to charge a price equal 	to or
below the price cap.
In 	Figure 	1 we 	have 	depicted 	the
price cap at P cap. 	Let us assume tha t this
price ceiling permits the monopolist to earn
FIGURE' • MONOPOLIST PRICING WITH LARGE
DECREASE IN COST
P1
P~AP ~~=l=+::~-:;""'~-------
z
MC 2
Q 	Q
1 	2
a normal rate of return (i.e., P cap equals the
price 	that 	would 	occur 	under 	rate-of-return 	regulation). 	As 	such, 	the 	monopolist's
unconstrained profit-maximizing price, PI, will be above the price ceiling. 	If the cost
reduction 	that 	arises 	under 	price 	cap 	regulation 	reduces 	costs 	significantly, 	the 	new
unconstrained profit-maximizing price, P 2• may be below the existing price ceiling (as shown
in Figure 1). 	In this case, both the firm and the consumer fare better under a price-cap
framework than under rate-of -return regulation (since price would remain at Pcap)' which
lessens the incentives to reduce costs and delays the onset of any price reductions.
It also is clear that if the cost decline is not large enough to bring the monopolist's
profit maximizing price below the ceiling, the monopolist will continue to charge the ceiling
price. 	Even in this case, however, consumers are not worse off, the stockholders of the
regulated firm are better off, and overall efficiency is promoted because under rate-of-return
regulation the monopolist would not have had the same incentives to reduce cost.
2. 	Cost Reductions TIult Would Occ", Ind~~nd~,.t of the Ty~ of R~gulatio,.
As with cost reductions that are induced by the incentives of price-cap regulation, other
cost reductions that are independent of the form of regulation (e.g., exogenous input price
declines) may also lead the monopolist to lower price. Whether there is a decline in consumer
prices depends again on whether the cost reduction results in the new profit maximizing price
to the monopolist being below or above the price ceiling.
16

,
.
However, under rate-of-return regulation, cost reductions (e.g., decline in input prices
which yield cost decreases) should ultimately result in lower consumer prices. 	Thus, under
rate-of -return regulation input price decreases leading to cost reductions will be translated into
lower prices whereas under pnce-cap regulation they may not be.
3. 	Price-Caps with Additional Consumer Safeguards
As noted in Section IV, there are additional safeguards that can be implemented that
would help insure that consumers share in the gains from both types of cost declines. One such
safeguard is to establish a formula that ensures that some percentage of excess profits are
shared with consumers. In this c;1se, the incentives to minimize costs remain because firms are
permitted to retain some of the earnings resulting from cost reductions.·· 	An alternative to
such earnings sharing plans is to update the price ceilings based on the excess earnings of the
monopolist.· 6 However, this latter solution may inhibit the cost minimizing incentives of the
firm, since future price reductions will be linked to current cost reduction activities. 	As
price ceilings are updated more often, price-cap regulation increasingly offers the same
disadvantages as rate-of -return regulation. Consequently policies which insure against firms
earning excess profits for long periods of time also reduce the incentive of firms to minimize
costs and innovate.
In light of this discussion, the Illinois Commerce Commission should consider applying
price-cap regulation to services that have not been classified as competitive. 	However, the
Commission might also consider adopting additional safeguards that insure that consumers
share in cost reductions that arise. This might take the form of including expected cost changes
into the price cap formula, and sharing excess earnings with consumers based on some
•• Although requiring a regulated firm to share excess profits with consumers could, in
theory, have no effect on the firm's incentive to reduce costs, implementing such a profit-
sliaring program, which would require (inter alia) that the regulators measure the firm's costs,
would be likely to introduce inefficiencies similar to those associated with standard rate-of-
return regulation .
• 5 	For a discussion of using the firms' performance in developing updated regulatory
decisions see Sibley (1989) supra note 30 and Brennan (1989) supra note 23.
17

predetermined formulae. 48 While it is difficult to know what particular earnings sharing plan
maintains the firms' incentives to operate efficiently and innovate, while providing adequate
consumer safeguards, permitting firms to retain some of the excess earnings is likely to result
in greater operating efficiency, innovation, and lower rates to consumers.
Finally, the Illinois Commerce Commission may wish to monitor the Quality of some
of the services provided by the local exchange companies. 	For some services, such as those
provided to interexchange companies, the ability to lower Quality is limited since the local
exchange company is bound by the equal access provisions of the MFJ. 47 For other services,
such as basic residential service, the Illinois Commerce Commission may wish to monitor
service Quality.
VI. 	Eatry lato latrastate Markets
As noted above, Illinois has allowed providers other than Illinois Bell and the other
local exchange companies to provide intraLATA services. 	We have examined the effects of
restrictions on entry into intraLA TA long distance markets. Our study of the issue indicates
that states which restrict entry have higher intraLA T A long distance service rates than states
which do not restrict such entry. We believe that this empirical work provides a strong basis
for continuing to permit entry into intraLATA toll markets.
A. Uslal IDtraLAT A Toll Senlce to Subsidize Local Senlce
48 In November 1989, the Illinois Commerce Commission approved a rate request from
Illinois Bell which contains some of the features of this type of regulatory framework. (See
Illinois Rate Case Order, Docket 89-0033, and Annual Report on Telecommunications, Il1inois
Commerce Commission (1989» Specifically, the order allowed Il1inois Bell's rate-of -return to
fluctuate and then dictated how earnings in excess of a specified level would be shared
between the company and consumers. 	In October 1990, however, an Illinois Appellate Court
ruled that the Il1inois Commerce Commission exceeded its authority in approving this request
because the regulatory framework constituted -retroactive ratemaking- by a public utility,
which is prohibited under the Illinois Public Utilities Act. (Illinois Bell Telephone Company v.
Illinois Commerce Commission, 1990 Ill. App. LEXIS ISSO (October 3. 1990» It should be noted,
however, that the Court did not address whether consumers would have benefitted under such
a regulatory framework. 	Consequently, we suggest that any future legislation make explicit
the Illinois Commerce Commission's authority to approve such regulatory frameworks for
noncompeti ti ve serv ices.
47 The provisions of the MFJ provide for equal access to the high Quality trunk lines.
18

.~.
Because subsidies from the interstate toll markets have declined. many states have
attempted to preserve the cross-subsidy to local service by restricting the entry of all carriers
into the intraLA TA toll market. and allowing only the local exchange companies to provide'
this service. 	As noted. Illinois has not followed this course. instead allowing resellers and
facilities-based companies to provide intraLA T A toll service. 4&
Attempts by state PUCs to subsidize local service by granting the local exchange
company a monopoly on intra LA TA long distance service are unlikely to benefit consumers
overall. 	Cross-subsidization results in allocative inefficiency because of the departure from
cost-based pricing. 4g 	Furthermore. by granting the local exchange company a monopoly
position for the provision of intraLA T A toll service and regulating the prices under rate-of-
return regulation, incentives to provide this service at minimum cost are diminished.
Illinois has been actively attempting to reduce the cross-subsidization of local exchange
service. 	In a plan approved by the Illinois Commerce Commission in 1983, the overall level
of subsidization from intrastate toll revenues to local exchange service was capped initially
and then was scheduled to be reduced by 20% a year for five years.5O
B. The Cost To LonE Distance Users
Mathios and Rogers (1990)51 have done an econometric analysis comparing BOC
intraLA T A toll rates in states that permit entry into intraLA TA markets with rates in states
that only permit the BOC to provide service. 	Rates charged by the BOCs for intraLA T A toll
service were found to be approximately 7.5 percent higher in states that restrict competition
both from facilities-based carriers and resellers than in states that do not restrict either type
4& 	Illinois has been actively attempting to reduce cross-subsidization of local exchange
service. 	In a plan approved by the Illinois Commerce Commission in 1983, the overall level
of subsidization from intrastate toll revenues was capped initially and then was scheduled to
be reduced by 20% a year for five years. 	See Fourth Interim Order of Docket 83-0 I 42.
4g The Illinois Commerce Commission is aware of the inefficiencies associated with cross-
subsidization. For example, in the Commission's 1989 Annual Report on Telecommunications
(pp. 16-20) there is a detailed plan to reduce the subsidy in order to encourage the "appropriate
and efficient pricing of telecommunications services."
60 See Fourth Interim Order of Docket 83-0142.
61 	See Mathios and Rogers (1990) supra note 6.
19

••
of service. 	In states that restricted entry and also took action to prevent unauthorized
provision of intraLA TA service, the price difference rose to 13 percent. 62 By contrast, states
that allowed resellers to provide service, but prohibited facilities-based competition, had prices
approximately equal to those in states that allowed both facilities-based carriers and resellers.
Consequently, it appears that allowing the capacity of the facilities-based carriers to be
utilized, whether directly by the facilities-based carriers or indirectly via resellers provides
competitive pressure on the BOC's pricing of intraLA TA toll service.
The study predicts that if all states were to allow entry into intraLA TA toll service,
the 	annual 	dollar 	savings 	to 	intrastate 	intraLA T A 	toll 	service 	customers 	would 	be
approximately $200 million. In light of these empirical findings, the current policy in Illinois
which permits entry into the intraLATA market, appears to benefit consumers.
VII. 	Conclusion
Article 13 of the Public Utilities Act, which granted pricing flexibility to providers of
telecommunications 	services 	classified 	as 	competitive 	and 	facilitated 	entry 	into 	some
telecommunications markets, expires in 1991. 	Based on the experience of Illinois and other
states that have reformed their regulation of telecommunication services, we conclude that
prices are likely to be lower in states that have granted pricing flexibility for intrastate
interLATA service. 	Consequently, the Illinois Commerce Commission may wish to continue
to allow pricing flexibility. 	Our empirical examination of toll prices indicate that pricing
flexibility within a price-cap framework leads to the lowest prices to consumers.
52 In many states it is difficult to distinguish between intra- and interLATA toll calls, so
prohibitions against interLA T A companies providing intraLA TA services at more competitive
rates may be ineffective. The response of the PUCs to this difficulty has been varied. Some
states that enjoin entry into intra LAT A service have taken action to prevent unauthorized
calls. For example, some states require interLA TA companies operating in their jurisdictions
to inform their customers that it is not legal to make intraLA TA calls on their system. Seven
PUCs have directed interLA T A carriers to install blocking equipment to prevent customers
from making intraLATA calls. For a detailed discussion of state policies towards intraLATA
toll service see Noll (1986) supra note 8.
20

Article 	13 granted pricing flexibility only to firms providing services that were
classified as competitive. Our theoretical analysis indicates that extending pricing flexibility
to services not classified as competitive may also result 	in 	lower 	prices to consumers.
Additional 	consumer safeguards, such as earnings sharing plans, may 	help 	insure 	that
consumers share in cost reductions that arise because of the enhanced incentives to minimize
costs under price-cap regulation and cost reductions that would occur even if rate-of -return
regula tion was still utilized.
Finally, our analysis indicates that permitting entry into intraLATA markets leads to
lower intraLA TA toll rates. Consequently, Illinois consumers may benefit if entry into these
markets continues to be permitted.
21