Effects of incentive regulation on the exercise of market power in the U.S. local telephone industry

The purpose of this dissertation is to empirically address the question of how incentive regulation affects pricing behavior of regulated firms. Specifically, this study examined whether price changes (or differences) after the adoption of incentive regulation were due to an increased or decreased exercise of market power while controlling for changes in cost, service quality, and the elasticity of demand in the U.S. local telephone industry.; A structural model derived from the "new empirical industrial organization (NIEO)" paradigm is developed to detect pricing behavior. The model is expected to be able to estimate and identify the degree of market power (pricing behavior) by using a system of behavioral equations based on oligopoly theory and comparative statics. To handle endogeneity in the behavioral equation model, the three-stage least squares estimator was used. To control for unobservable state-specific variables, a fixed effects model was employed using a panel data set. The state LEC-level data are collected from diverse sources including the FCC's ARMIS (Automated Reporting Management Information System) database on the FCC's web site on the Internet.; The results show firms under price cap and earnings sharing regulation tend to set prices higher above marginal cost than under rate-of-return regulation. The results also show the existence of economies of scale in residential local telephone service. The higher markup for low-elasticity local service could thus result in better allocative efficiency since the FDC-based (Fully Distributed Cost) price under ROR regulation tends to be lower than the second-best Ramsey price. Since residential local rates have generally been decreasing, the efficiency gain from incentive regulation seems to outweigh the loss in equity.