Given the deficiencies of rate-of-return regulation, the FCC and state regulators have considered alternative approaches. Chief among these are price- focused regulations, or price caps. This regulatory approach, a fundamental change from the current system, simulates competition without the presence of competing firms by limiting what is charged. Under price caps, regulators apply rules so that the average price of a basket of services remains the same. Prices of individual services within a basket may rise or fall.
This scheme permits a phone company to change its prices as it wants in order to meet competition or bring user charges more into line with costs. But so long as the prices of basic services stay within the established range, regulatory approval of price changes is guaranteed. This approach lets a phone company revise its rate structure without facing delays.
There are two features to keep in mind when analyzing price caps. Both encourage efficiency: productivity index and profit sharing.
The productivity index is part of an annual adjustment made to price caps to account for the rate of inflation. Rather than just adding the full inflation increase to the price cap, the company first subtracts a productivity index. The adjustment is necessary because telecommunications costs historically have grown more slowly than overall inflation due to technological progress. The productivity index tends to be high where the particular price cap involves a usage-based service, because costs per message unit have declined about 2.5 percent per year. For non-usage-sensitive prices such as basic local service, the index would be less or none at all, resulting in a higher inflation increase. The index pressures companies to meet or exceed anticipated increases in productivity: If the company beats the index target, it keeps the rewards of its efforts.
Setting a productivity index is a critical step in price cap regulation. If the index is set too high, the adjustment formula may allow no room for profits, undermining the financial health of the company. Increases in productivity are not inevitable; productivity growth can drop off for unexplained reasons, as happened between the 1960s and 1970s in the entire world economy. But if the index is set too low, technological developments may lead to rapid productivity gains and cause profits to be unacceptably high. So price caps