INCENTIVE REGULATION AND THE COST-STRUCTURE OF THE LOCAL TELEPHONE EXCHANGE NETWORK

This paper combines an engineering process model of the cost of focal exchange telecommunications firms with an analytical model of optimal incentive regulation (with ex post cost observability), to study empir ically the properties of the optimal regulatory mechanism. Relying on detailed properties of the cost function, we examine three issues: (i) the extent of natural monopoly when informational rents associated wi th regulation are taken into account; (ii) the extent of incentive cor rection, which expresses the divergence of pricing under the optimal m echanism from optimal pricing under complete information; (iii) the im plementation of optimal regulation through a menu of linear contracts. Our findings are that, for fixed territory, strong economies of scale allow local exchange telecommunications to retain monopoly characteri stics even when the (informational) costs of regulation are properly a ccounted for, the incentive correction term is small in magnitude, and that optimal regulation can be well approximated through relatively s imple linear contracts.