Superior regulatory regimes in theory and practice

A substantial body of recent research finds thatprice-cap regulation is superior tocost-based regulation in that many of the distortions associated with the latter are reduced or eliminated entirely. We prove that the hybrid application ofcost-based and price-cap regulation that characterizes current regulatory practice in the United States telecommunications industry may generate qualitative distortions greater in magnitude than those realized undercost-based regulation. It follows thatprice-based regulation in practice may be welfare-inferior tocost-based regulation. The analysis further reveals that the firm subject to this modified form ofprice-based regulation may have incentives to engage in pure waste.