Assessing the Performance of the Price Cap Plan for Local Exchange Carriers in the United States

In 1991 the FCC implemented a price cap plan for local exchange carriers' interstate access service designed to deal with the regulatory boundaries problem arising from the breakup of AT&T in 1984. The experience with the price cap plan demonstrates the difficulty of predicting productivity growth accurately and makes clear that regulators cannot depend upon a pure price cap plan to keep prices within a reasonable range of costs. With periodic reviews to readjust plan parameters, however, a price cap plan can maintain the rate-of-return close to the target rate-of-return without diminishing the price cap plan's incentives for efficient production. A simple method of recalculating the X-factor based on the rate-of-return over the previous three years worked well in simulations. If this procedure had been used over the price cap period 1991 to 2000, prices would have been 20 percent lower and expenditures on LECs' telecommunications service subject to a price cap would have been $3.8 billion lower.