Incentive regulation and the change in productive efficiency of local exchange carriers

Incentive regulation is now an important regulatory tool in the telecommunications industry in the United States. The issue that is explored here is whether incentive regulation in the form of a price cap for interstate access service to local loops has resulted in an increase in productive efficiency. The methodology for measuring the effects of incentive regulation on productive efficiency is data envelopment analysis (DEA). The results of empirically implementing the DEA approach indicate that most local exchange carriers (LECs) were technically efficient over the 1988–1998 period. Three LECs, however, consistently demonstrate scale inefficiency while two LECs show continued improvement in scale efficiency, attaining optimal scale efficiency by 1998. Finally, in the aggregate, there is a small, but clearly identifiable, improvement in aggrega LECs' technical efficiency (TE) between 1988 and 1998. This sort of improvement is precisely what incentive regulation in the form of price caps was designed to promote.