Incentive regulation has become widespread in telecommunications. By assessing the strengths and weaknesses of plans that are currently in place, this study uncovers the central principles that underlie sound and effective incentive regulation. Under conditions of rapid change and great uncertainty, incentive regulation, which encourages a company toward goals but allows it some discretion in reaching those goals, should work better than rate of return regulation, which estimates a company's costs and then limits the amount of return the firm can earn. Given the uncertainty that exists in telecommunications today about consumer demand and the nature of production technology, it is no surprise that regulatory commissions have recently implemented a variety of incentive regulations. Sappington and Weisman review the current conditions of the telecommunications industry and explore the merits of providing regulated firms with options in incentive regulation plans. They describe the difficulties regulators face in dealing with incomplete information about companies' activities, in establishing credibility, and in avoiding the dangers of asymmteric regulation (where regulation imposed on new entrants differs from rules for established companies). They close by analyzing competition in long-distance telephone services as it pertains to incentive regulation and by reviewing recent empirial studies.

About the Author

David E. M. Sappington is the Lanzillotti-McKethan Eminent Scholar in the Department of Economics at the University of Florida.

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