Methods of Regulation Rate of return Incentive systems –Rate freeze –Rate bands or ranges –Price Caps

Problems with the ROR method? Leads to “gold plating” Lack of incentive to be efficient Lack of incentive to be innovative

Price Caps Regulate price movement, instead of cost Attempt to control cross subsidization by creating baskets of services –Regulate how prices move within a basket In theory, was to create incentive to be innovative and efficient by not controlling earnings –Did continue to monitor earnings, however –Created a sharing mechanism

Price Cap Approach Use of Indexing What are indexes and how do they work? Example: Consumer Price Index (CPI) –Market basket of consumer goods –Price monitored over a period of time

Consumer price index example Year 1: market basket costs $25 –Initialize the index at 100% Year 2:market basket costs $25.50 –The index is 102% from Year 1 Year 3: market basket costs $26.55 –The index is 104% from Year 2 –The index is 106.2% from Year 1

Price Cap Process First Step is the calculation of Price Cap Index (PCI) –PCI = an index of changes in inflation, carrier productivity and any changes beyond the carrier’s control –PCI new = PCI last yr + change in GNP-PI – productivity offset + (increase of decrease caused by cost changes)

PCI example Assume the following: –Last year’s PCI was 101% –The change in the Gross National Product- Producer Price Index since last year was +5% –The productivity offset is 3% –There are no pertinent cost changes PCI new = 101% + 5% - 3% = 103%

The next step Calculating the Actual Price Index (API) API = index of proposed prices weighted by base period demand and pricing API cannot be greater than the PCI

How do you calculate the API? Refer to the handout provided in class –This is just to complicated to do on a slide

Effects of Price Caps Expedited tariff filing period Return to historical demand data Continued reliance on cap on earnings, at least for awhile; but carriers did get to keep more of their earnings Shifted the discussion away from cost—to demand Got away from a purely cost plus approach