Global Price Cap and Incentives to Exclude

Recall that a major drawback of LRIC regulation is that it does not allow the operator to make a margin on its bottleneck segment. The operator then has strong incentives to deny access to its rivals through nonprice methods, which in turn call for close monitoring by regulatory agencies. Incentives for exclusion are much attenuated if treatment of accessservices as a normal business segment is allowed and the operator can make money on them.

Under a global price cap (GPC), the operator manages its product lines "symmetrically," as it has no built-in incentive to favor one over another. In particular, excluding buyers of interconnection services amounts to mutilating a potentially quite profitable activity. A global price cap provides the operator with the flexibility to choose which product lines, retail or wholesale, are profitable. The theoretical analysis confirms that behavior that excludes rivals, raises their costs, or limits their demand tends to reduce the operator's profit. This reduction is particularly clear in the case where rivals have no market power and the exclusionary practice consists in raising the rivals' cost. The exclusionary practice then is tantamount to the operator's raising its own cost of providing the retail service through the competitive rivals. In contrast, we saw that even in this simple case the operator has a strong incentive to exclude under fragmented regulation. Therefore, one should not hastily transpose concerns that are legitimate under fragmented regulatory schemes to global price cap regulation.

Global price caps thus enable regulation to be more light-handed, for global price caps reduce perverse incentives and therefore diminish the need for regulatory oversight of the operator's decisions. A global price cap scheme, therefore, is more compatible with deference to the operator's business judgment than existing schemes. A global price cap, however, still involves discretion with respect to the weights in the cap and to their revision process.

Global Price Cap and Predation Global price caps raise the possibility of predation. To the extent that predation is often mingled with exclusion, a more common practice, this fear may be exaggerated, for we have observed that a global price cap tends to eliminate, rather than create, incentives for exclusion.

A price squeeze, however, is easy to carry out under a global price cap: The operator can increase the access charge and reduce its final price while keeping the price cap constraint satisfied. It thereby hurts its rivals on the retail market considerably. One can then conceive of use of this strategy for predatory purposes. That is, the operator might reduce its profit until the next price review, but eliminate rivals who otherwise would have been used by the regulator as benchmarks in the future. The profitability of such predatory behavior unfortunately has not yet been analyzed; one can only presume that the threat of predation is more relevant when competitors do not have a long purse and when their assets cannot easily be purchased and managed by another company in case of bankruptcy.

Three Factors Limiting the Power of Incentives

We have already observed that asymmetric information allows regulated firms to extract large rents under high-powered incentive schemes. This possibility in turn motivates the use of cost- or earnings-sharing schemes. This section investigates three factors that make sharing by consumers or by the government particularly desirable.

1 Quality Concerns

A well-known drawback of high-powered schemes is that they make it very costly to firms to supply quality. The provision of quality raises cost and is therefore borne entirely by the firm if the latter is residual claimant for its cost performance. The firm may, therefore, decide to skimp on quality if quality is not minutely specified in the regulatory contract. In contrast, low-powered schemes, by failing to make the firm accountable for its cost performance, make it very cheap to supply quality.

This point is well known. Indeed, the U.S. Department of Defense has often invoked it to motivate the use of cost-plus contracts in contexts in which quality is a sensitive issue and its specifications are hard to pin down exactly in the initial procurement contract with the defense contractor. Similarly, the argument has been made several times that the introduction of incentive regulation for power companies conflicts with the safe operation of nuclear power plants. As a last illustration, quality started deteriorating shortly after British Telecom's 1984 privatization and design of more powerful incentives in the form of a price cap, and quality standards and verification mechanisms had to be set up as a consequence.

There is a natural complementarity between powerful incentive schemes and a close monitoring of quality standards. If the regulator is unable to specify the standards or to monitor compliance with these standards, then there may be no other choice than the adoption of low-powered incentives.

2 Regulatory Commitment

Regulatory contracts are generally much shorter than the relationship between the regulatory authority and the regulated firm. They do not exceed five years for price cap regulation and are usually shorter under other forms of regulation.

Let us for the moment assume that the official length of the contract is respected, so that the regulatory review will occur at the expiration of the current regulatory contract. And consider a high-powered incentive scheme covering the length of the regulatory contract. It is clear that even though the firm is formally residual claimant for its cost savings, an effort to reduce cost by $1 is not rewarded $1 overall. A lower cost will convince the regulatory authority of a higher efficiency and will make it more demanding in the regulatory contract designed for the firm at the next regulatory review. So while a $1 cost reduction yields $1 to the firm in the short run, it also entails a long-term penalty in the form of higher performance requirements at the next review. This is the well-known ratchet effect. The ratchet effect imposes a bound on the incentives that can be provided even by formally high-powered incentives.

In practice, the actual length of the regulatory contract may be shorter than its formal length. That is, the contract may be renegotiated before the next regulatory review. On the one hand, the regulator, usually under political pressure, may be tempted to force the firm to renegotiate before the end of the contract when the latter makes substantial profits. Such renegotiation exacerbates the ratchet effect and makes the firm even more cautious about taking full advantage of (formally) high-powered incentives to reduce cost. On the other hand, the firm may force the regulator to renegotiate midway and offer more favorable terms if the initial contract proves unprofitable and makes credible the threat of bankruptcy or at least that of forgoing investments that the regulator deems necessary. The firm is then said to face a "soft budget constraint," since it is rescued by the regulator despite a commitment not to intervene before the next regulatory review. A high-powered incentive scheme raises the likelihood of the occurrence of either situation (very high or very low profits) and therefore of contract renegotiation. Because in both cases contract renegotiation ex post rewards the firm's inefficiency (punishes its cost-reducing effort), early regulatory reviews further decrease the real power of formally high-powered incentive schemes.

3 Regulatory Capture

The debate on incentive regulation focuses on the agency problem between the regulator and the regulated firm. There is in practice a second agency problem, namely, that between the general public and the regulator. And, as we will see, the two agency problems may interact in an interesting way.

Understanding the second agency problem requires asking why there is a regulator in the first place. Quite clearly, the regulator is an informational intermediary. The members of the collectivity face a collective action problem. They individually have no incentive to make the very heavy investment required for a good understanding of both the technology and the economics of telecommunications. This free-riding problem is somewhat alleviated by the election of political representatives, who themselves are informational intermediaries. But the free-riding problem subsists, in an attenuated but still substantial way, at the congressional level. It is resolved only (and still imperfectly) by the creation of specialized congressional committees and bureaucratic agencies.

In a nutshell, congressional committees and regulatory agencies are "informational intermediaries," "delegated monitors," or "supervisors." Their role is to fill some of the informational gap between the collectivity and the industry. But this informational expertise is precisely what provides the delegated monitors with discretionary power and what creates the second agency problem. This second agency problem can be divided into two parts. First, the informational intermediaries may not have sufficient incentives to collect the information about the technology and the economics of the industry, in the same way the regulated firms may not have enough incentives to control their cost. Second, when endowed with a given amount of information, the informational intermediaries may not make use of this information in the direction that would benefit the collectivity. That is, they may abuse their discretion.

Here, we are interested in this potential for abuse, and in particular in the possibility that the informational intermediaries are captured by interest groups. Political scientists (Montesquieu, the American Federalists, Marx, Bernstein, . . . ) and economists (the Chicago school with Stigler, Posner, Becker, and Peltzman, and the Virginia school with Buchanan and Tullock) have long recognized the threat posed by interest-group politics for the efficiency of economic regulation.

For an economist interested in regulatory design and reform, the interesting question, though, is not the existence of a threat of capture, but rather what is to be done about it. To approach this question, we must, as we discussed, first explain why regulators have discretion and so may collude with interest groups. Their role as informational intermediaries seems crucial in this respect. It is precisely because their principal (the full Congress or the collectivity as a whole, depending on the interpretation) is uncertain as to the ranking of alternative policies that informational intermediaries can get away with policies that favor specific interest groups to the detriment of the collectivity. Furthermore, a delegated monitoring approach not only explains why there is scope for regulatory capture, but also suggests policies that will reduce the likelihood of capture, as we now illustrate in the context of incentive regulation.

Recall that high-powered incentive schemes are associated with high rents, and therefore with high stakes for the regulated firm. High-powered incentives thus generate for the regulated firms a large benefit from capturing their regulators. Using a procurement example, and in the presence of uncertainty about the firm's cost, the regulator has a lot of discretion when designing a fixed-price contract, in that the level of the fixed price is highly subjective and affects the firm's welfare substantially. In particular, when the regulator obtains information that the firm has a low cost, a piece of information that if disclosed would permit the elimination of the firm's potential rent, the regulator may be lenient with the firm and "forget" the information he acquired. In contrast, a cost-plus contract is more mechanical, and regulatory decisions have a much lower impact on the firm's welfare. A cost-plus contract is therefore less sensitive than a fixed-price contract to the risk of regulatory capture by the regulated firm (at least when good accounting procedures are in place).

The reader may wonder whether the influence of the regulated firm might not be offset by that of interest groups with opposite interests. Indeed, taxpayers in a procurement context and consumers in a regulatory context are hurt when the firm enjoys a rent, since they then have to pay higher taxes and prices for the services, respectively. It can be shown, however, that, even if they solve their collective action problem and are properly organized, taxpayers or consumers do not form an effective counterpower to the industry when they lack the information about policy rankings. But this lack of information is precisely what motivated the use of an informational intermediary in the first place. Put differently, collusion may occur among members of a "nexus of information," that is, between economic agents sharing information; it is for this reason that collusion is an important matter in situations of delegated monitoring.

The delegated-monitoring view of regulatory agencies, therefore, leads to the following implication for incentive regulation: low-powered incentive schemes, because they are less discretionary (make less use of the regulator's private information), are more robust to regulatory capture; it is therefore advisable to lower the power of incentive schemes when the threat of capture by the regulated firm is serious. Or put differently, the adoption of high-powered schemes must go hand-in-hand with the existence of political and bureaucratic institutions that alleviate the capture problem.

More generally, the delegated monitoring view identifies four types of policies with a potential to curb regulatory capture. The first two aim at reducing the gains from collusion; the last two make it more difficult for the parties to collude to reap those gains.

Reduction of Regulatory Discretion The use of low-powered incentive schemes is an illustration of a more general principle: Substantial regulatory discretion—that is, a high sensitivity of regulatory decisions to the regulatory agency's assessment of the regulated firm's cost and demand environment—creates high stakes for the interest groups and therefore a concern about regulatory capture. The potential for regulatory capture, therefore, reduces the use that is made of the regulators' private information and thereby creates a more bureaucratic environment. We will later offer other examples of reduced stakes and less discretionary policies.

Making Regulators Accountable by Offering Them a Stake Another way of fighting capture is to make regulators internalize at least partly the welfare of other groups so as to induce them not to favor a specific interest group. Let us here provide some analogy. A lead investment bank, leveraged buyout specialist, or venture capitalist brings investors to buy a new debt or equity issue; it thereby acts as a delegated monitor. It specializes in acquiring information about the issuer not held by the other investors. But, of course, it may also collude with the issuer, possibly getting some kickback on the side. To reduce the risk of collusion (as well as to encourage the collection of information), investors require the lead investment bank, leveraged buyout specialist, or venture capitalist to take a stake in the issue. The incentives of the delegated monitor and the principal (the investors) are then better aligned. Stake taking by delegated monitors is actually a widespread institution in situations in which the principal's welfare is easily measurable.

Alas, what works well in financial environments is less effective in a regulatory context. Stake taking by the regulator would mean that the regulator's salary would be made contingent on the amount of money paid by taxpayers (in a procurement context), on the level and structure of consumer prices (in a regulatory context), and possibly on the quality of service (in both contexts). It is clear that such performance measures either are hard to specify exactly ex ante, or when they can be easily described, as in the case of the taxpayers' bill, they lack a natural benchmark (in contrast, the benchmark can be the market rate of return in the financial investment analogy). So, in general, it is difficult to prevent capture by providing regulators with monetary incentives that would align their interests with those of taxpayers or consumers.

Making Collusion More Difficult We have not yet discussed the process of capture. In general, the regulator may be willing to do a favor to an interest group if a quid pro quo is available. This quid pro quo in practice takes many forms: direct monetary transfer (as in most cases of corruption), campaign contributions for politicians, lack of complaint about the regulatory activity, future employment as a top executive or consultant (the revolving door), friendship, entertainment expenditures, and so forth. The nature of the bribe varies greatly with the situation and with the personality of the parties involved in the capture process.

One may try to reduce capture by making these quid pro quos more costly to the parties. But such policies have also a cost. For example, the prohibition of the revolving door may make it difficult to find qualified regulators if industry executives envision that they will not be able to return to the private sector when they quit the regulatory agency. It is only recently that economists have started developing formal models of the impact of regulatory institutions on the ease with which transfers can respond to stakes and facilitate capture.

Reduction of the Asymmetry of Information between Regulators and Their Principal To the extent that capture is related to the regulators' informational superiority over their principal (full Congress, collectivity), a reduction in this informational asymmetry reduces the scope for capture. Obviously, one should not expect too much from such policies, since delegated monitoring is the heart of the problem. But some steps can be undertaken that reduce the manipulation of information by regulators. In particular, and following the Anglo-Saxon tradition of transparency, one can force regulators to adopt a very open process: open regulatory hearings, use of consultative documents, independent appeal procedures, written and detailed explanation of decisions, and so forth. Transparency gives the regulators' principal access to other sources of opinion (interest groups such as customers and competitors), to data, and to the regulators' reasoning. It alleviates, although it does not eliminate, informational asymmetries between the delegated monitor and its principal.