Designing Incentive Regulation for the Telecommunications Industry.

Lyon, Thomas P.

By David E. M. Sappington and Dennis L. Weisman.

Cambridge, MA: The MIT Press/The AEI Press, 1996. Pp. xiv, 388. $35.00.

For the better part of a century, key network industries - such as electric power, natural gas, telecommunications, water, and cable television - have been regulated through controls on the rate of return they earn on capital invested. For much of this time, economists have lamented the shortcomings of rate-of-return regulation, pointing especially to its weak incentives for cost reduction and innovation. Indeed, a rich theoretical literature has emerged that derives optimal regulatory policies for settings in which the regulator has limited information about the regulated firm's costs and/or demand. These policies are specifically designed to give regulated firms incentives to cut costs, make desirable investments in capacity and service quality, and make public their private information about market conditions.

The academic literature on incentive mechanisms has had limited impact in policy circles, in part because it is just too technical for most policymakers to comprehend. The present volume takes a big step toward bridging the gap between theory and practice in the design of regulatory policy. Written by two authors with expertise in both the design of regulatory mechanisms and their application in the telecommunications industry, this book is a model of clarity and practical usefulness for policymaking. No one has contributed more to the theory of regulatory incentives than David Sappington, and few academics boast Dennis Weisman's mix of scholarly credentials and industry expertise. Together, they deliver their message in clear, readable prose, with a minimum of technical jargon.

The book is important because the telecommunications industry is in the midst of rapid and revolutionary technological change that requires ongoing institutional adaptation. In addition, the regulatory arena is filled to overflowing with self-serving arguments made by interested parties. A balanced appraisal of the issues is critical if regulation is to grease the wheels of change instead of gumming them up. Indeed, the potential for regulatory gridlock has been driven home by the U.S. experience in implementing the 1996 Telecommunications Act. The Act was designed to hasten competition in telecommunications but has instead bogged down in a morass of interest group battling. Perhaps such outcomes can be avoided in the future if policymakers have a better grasp of the incentives created by the rules they promulgate.

The book should appeal to several groups of readers. First and foremost, it belongs on the shelves of state and federal policymakers in the telecommunications industry. Second, regulators who wish to transfer lessons from the telecommunications industry to other industries will also find the book enlightening. Third, academics who want a better understanding of telecommunications, an intuitive introduction to the design of regulatory mechanisms, or a survey of the empirical work on the performance of incentive regulation will find it useful. Fourth, teachers in business, law, and public policy schools will enjoy using it in courses that discuss recent developments in regulatory policy. Fifth, consultants who work with incentive regulation will appreciate the book's comprehensive and balanced coverage.

The volume is organized into 12 chapters. The first provides an introduction and overview, including a list of "Ten Myths of Incentive Regulation." The last chapter revisits the "Ten Myths," answering them with a set of "Ten Facts About Incentive Regulation," and sums up the book with a list of 25 specific policy recommendations. In between, the book has three main components: (i) A survey of the structure and regulation of the telecommunications industry (Chapters 2-3), (ii) a guide to the design of regulatory incentive programs (Chapters 4-9), and (iii) an analysis of the performance of incentive regulation plans to date (Chapters 10-11). Throughout, the authors take pains to highlight the policy recommendations that emerge from their analysis.

To convey the flavor of the book, consider a representative "myth" and the authors' rejoinder. Myth 6 states: "Substantial earnings by the regulated firm under an incentive plan constitute strong evidence that regulators were lax either in formulating or in implementing the plan. (p. 332)" This is countered by Fact 6: "Substantial earnings by the regulated firm under an incentive plan can provide strong evidence that the plan is working as intended. (p. 337)" Indeed, it is hard to provide incentives if there is no reward for good performance. Points such as these will not surprise students of mechanism design, but such readers are not the target audience. The "myths" discussed are intended to help inoculate policymakers against the shallow arguments so often proffered in regulatory proceedings. The political appeal of Myth 6, for example, is enormous. Whenever regulated firms do well under an incentive plan, "pro-consumer" groups are sure to come forth calling for rate reductions to eradicate the "obscene profits" earned by the utilities. Without the possibility of significant rewards for performance, though, regulated firms have little incentive to work hard improving service quality and cutting costs. While rate reductions may benefit consumers in the short run, their long-run impact can be to undermine the regulated firm's incentives to perform well in the future. Policymakers need to see clearly the pitfalls of a myopic approach to regulation.

It is traditional for reviewers to point out flaws and limitations in the books they review. In the case at hand, this is a bit of a challenge, but for the sake of completeness, two points might be made. First, the book includes an occasional bit of mathematical analysis, as in the Appendices to Chapters 3, 5, and 9. These sections serve little purpose, as they are too stripped-down for technical readers and are unlikely to be of much value to the nontechnical readers who form the core of the book's audience. Still, little harm is done, since the appendices can easily be skipped over without losing the flow of the book. Second, Chapter 9 provides a discussion of whether Regional Bell Operating Companies (RBOCs) should be allowed into the long-distance telecommunications market. The chapter mainly rehashes arguments made by various interested parties to certain regulatory proceedings, and it lacks the coherence and focus of most of the other chapters. In addition, this chapter suffers from the appendix problem just discussed. Still, the chapter addresses an important policy issue, it's short, and it needn't distract readers primarily interested in the more general aspects of incentive regulation.

Overall, there is much to praise and little to criticize in this monograph. It does an admirable job of bringing a well-developed and complex theoretical literature to bear on problems of practical importance. Sappington and Weisman have provided an excellent how-to manual for anyone interested in the design of regulatory policy for the network industries.

Thomas P. Lyon Indiana University