The political economy of price cap regulation

The last decade has witnessed a dramatic substitution of price cap regulation for rate-of-return regulation in the telecommunications industry. The 1996 Telecommunications Act empowers state regulators to set the terms of competitive entry in local telephone markets. We investigate whether the form of regulation endogenously affects the regulator's behavior with respect to competitive entry. The evidence reveals that regulators in price cap jurisdictions tend to set more liberal terms of entry in comparison with regulators in rate-of-return jurisdictions. This suggests that price cap regulation suffers from incomplete contracting, undermining the potentially superior incentive properties of this important regulatory reform.