Does practice follow principle? Applying real options principles to proxy costs in U.S. telecommunications
This paper analyzes whether current practices in estimating incremental costs for regulated telecommunications companies provide them with efficient investment incentives. In implementing the Telecommunications Act of 1996, regulators are using incremental cost studies, with some markup for shared costs, to establish prices for interconnection, reciprocal compensation, unbundled network elements, and universal service. Regulators use these incremental cost estimates, which come from proxy cost models, to set upper bounds on these prices. This is a significant change from past practices, where incremental cost studies were used for setting price floors for competitive or potentially competitive services.
This new application of incremental costs has prompted new debates about cost studies. The applicability of real options investment analysis is one of these debates. The use of real options is analyzed by considering a model in which the regulator affects ILEC investment decisions and market outcomes through price controls. It shows that existing TELRIC models tend to discourage efficient ILEC investment by understating incremental costs and that the inefficiency is not as great as the real options proponents claim.
KeywordsMarginal Cost Incremental Cost Real Option Federal Communication Commission Demand Uncertainty
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