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Journal of
Economic Measuring the change in
Studies
29,2
productive efficiency in
telecommunications in the
150
USA
Noel D. Uri
Competitive Pricing Division, Common Carrier Bureau, Federal
Communications Commission, Washington, DC, USA
Keywords Telecommunications industry, Regulations, USA
Abstract Incentive regulation has become an important regulatory tool in the
telecommunications industry in the USA. The issue explored here is whether incentive
regulation has resulted in an increase in productive efficiency. After providing an overview of
the nature of incentive regulation, a methodology for measuring technical efficiency and its
change is introduced. This is a multiple-output/multiple-input distance function approach to
measuring technical efficiency. The results of implementing this approach for 19 local exchange
carriers for the 1988-1999 period indicate that, in the production of local service, intrastate toll/
access service, and interstate access to local loops, there was no change in technical efficiency
between the 1988-1990 and the 1991-1999 periods, something that incentive regulation was
specifically designed to promote.

Introduction
An important regulatory tool in the telecommunications industry in the USA is
now incentive regulation. A number of factors led away from rate-of-return
(cost-based) regulation and toward a regulatory approach that ostensibly
provides incentives for increasing productive efficiency, thereby allowing firms
to share in the social gains from efficiency with increased profits.
The basic structure of incentive regulation, as it has most commonly been
adopted in the telecommunications industry in the USA, is in the form of price
caps. The issue that will be explored below is whether, de facto, price caps have
resulted in an increase in productive efficiency. Before exploring this issue,
however, some background is needed.

Journal of Economic Studies,
Vol. 29 No. 2, 2002, pp. 150-167.
# MCB UP Limited, 0144-3585
DOI 10.1108/01443580210420808
Background
For several decades, there has been substantial criticism of rate-of-return
regulation. From the initial formal analysis by Averch and Johnson (1962),
concerns have centered on the potential for inefficiencies. It was suggested that
a profit-maximizing firm under rate-of-return regulation fails to minimize the
cost of producing any observed level of output, that these productive
The views expressed are those of the author and do not necessarily represent the policies of the
Federal Communications Commission or the views of other Federal Communications staff
members.
inefficiencies might be large, and that the firm might even build up its rate base Measuring the
by selling competitive outputs at a price below marginal cost. Although a change
number of questions have been raised over the years about the original
analysis, many of the basic concerns about rate-of-return regulation persist
(Kahn, 1970; Sherman, 1985, 1992).
Despite the concern with the presence of inefficiencies under rate-of-return
regulation, it was not abandoned in the telecommunications industry until the 151
1980s. The developments crucial to ushering in the era of incentive regulation
in telecommunications are discussed in the Notice of Inquiry in the Matter of
Price Cap Performance Review for AT&T (7 FCC Rcd No. 17). In this Notice of
Inquiry (NOI), two factors are identified, including the increasing degree of
competition and rapid changes in technology in telecommunications markets
as the rationale for adopting incentive regulation:
The Commission began development of the AT&T Price Cap Plan in 1987, as part of a
fundamental reappraisal of the rate regulation it applies to telecommunications common
carriers. The reappraisal was precipitated by the changes that have swept the
telecommunications industry in the last few decades. . . . Traditional ``cost-plus'' rate of return
regulation focuses on establishing a reasonable limit on the carrier's profits . . . The
limitations and drawbacks of such ``cost-plus'' regulation include distorted incentives in
capital investment, encouragement of cost shifting, when the carrier also participates in more
competitive markets, and little incentive to introduce new and innovative services. The
Federal Communications Commission has concluded in the past that rate of return regulation
does not encourage optimal efficiency. Under traditional rate of return regulation, the carrier's
allowed profits are computed from its total invested capital, whether or not the carrier is
using capital, labor, operational methods and pricing in the most efficient manner. To
maximize profits, the company has an incentive to manipulate its inputs of labor and capital,
without regard to efficiency, and to adopt strategies and pricing based on what it expects the
regulatory agency might wish, not necessarily what best serves its customers and society (7
FCC Rcd No. 17, p. 5322).
Rate-of-return regulation, as noted previously, has been replaced by incentive
regulation in the telecommunications industry. Incentive regulation has a
number of desirable properties. These include technical efficiency (i.e. short-run
cost minimization), dynamic efficiency (i.e. long-run cost minimization),
enhanced service quality and consumer welfare, and reduced costs of
regulation. Incentive regulation plans also often have socially beneficial equity
and redistributional properties. Thus, preserving low basic local service rates is
a common property of incentive plans. In some situations, a precondition for
earnings sharing or other departures from strict rate-of-return regulation is a
freeze on basic local service rates for the duration of the incentive plan. Rate
stability is a broader, but related objective of incentive regulation (Kridel et al.,
1996). Additional desirable properties suggested by Littlechild (1983), one of
the earliest proponents of incentive regulation, include the protection of
consumers against monopoly, promotion of competition, enhancement of
innovation, and improvement of the profitability of the regulated firm.
There has been considerable discussion regarding the extent to which these
beneficial objectives can be realized. Some of this discussion has been at the
theoretical level. For example, a comparison between innovation under rate-of-
Journal of return regulation and under incentive regulation is provided by Cabral and
Economic Riordan (1989). Their results generally support the identifiable beneficial
Studies properties of incentive regulation. With incentive regulation, Vogelsang (1988,
1991) demonstrates convergence to efficient prices (both access and usage)
29,2 under stationary cost and demand conditions, while Brennan (1989) finds that
cost and demand change when this convergence does not occur.
152 With regard to the implementation of incentive regulation, a number of
practical concerns have been raised. For example, Sappington (1980) argues
that incentive regulation introduces the potential for pure waste and involves
the purchase of inputs which have no productive value. Kridel et al. (1996), on
the other hand, survey a number of empirical studies that ostensibly provide
evidence that productivity, infrastructure investment, profit levels and new
service offerings have increased under incentive regulation. It appears,
therefore, that the attainability of many of the desirable properties of incentive
regulation is an empirical issue.

Incentive regulation and price caps

Incentive regulation is typically defined as the implementation of rules that
encourage a regulated firm to achieve desired goals by granting some, but not
complete, discretion to the firm. Three aspects of this definition of incentive
regulation are important. First, regulatory goals must be clearly specified
before incentive regulation is designed. The properties of the best incentive
regulation plan will vary according to the goals the plan is designed to achieve.
Second, the regulated firm is granted some discretion under incentive
regulation. For example, while the firm may be rewarded for reducing its
operating costs, it is not told precisely how to reduce these costs. Third, the
regulator imposes some restrictions on relevant activities or outcomes under
incentive regulation (Baron, 1991; Bernstein and Sappington, 1999).
One popular incentive regulation plan is the price cap plan. The central idea
behind price cap regulation is to control the prices charged by the regulated
firm, rather than its earnings. Essentially, price cap regulation plans require the
regulated firm's average real prices to fall annually by a specified percentage
(Mitchell and Vogelsang, 1991). This percentage is nominally referred to as the
``X-factor'' or the productivity offset.
In the case of incumbent local exchange carriers (LECs) regulated by the
Federal Communications Commission, a price cap index (PCI) for common line
interstate access and for traffic-sensitive, switched interstate access is adjusted
annually pursuant to the PCI relationship defined in the Code of Federal
Regulations[1]. The PCI relationship consists of a measure of inflation, in this
case the Gross Domestic Product Price Index (GDP-PI), minus the X-factor, plus
or minus any permitted exogenous cost changes.
For LEC interstate access service, it has been argued in the Price Cap
Performance Review for Local Exchange Carriers in 1995 (10 FCC Rcd at 9002)
that applying price cap regulation allows the Federal Communications
Commission (various), as closely as possible, to replicate the effects of a
competitive market. That is, competition should be the model for setting just Measuring the
and reasonable LEC rates based on a PCI, because ``Effective competition change
encourages firms to improve their productivity and introduce improved
products and services, in order to increase their profits. With prices set by
marketplace forces, the most efficient firms will earn above-average profits,
while less efficient firms will earn lower profits, or cease operating. Over time,
the benefits of competition flow to customers and to society, in the form of 153
prices that reflect costs, maximize social welfare, and efficiently allocate
resources'' (p. 9002).

Measuring the change in productive efficiency

As noted, whether the desirable properties of incentive regulation are realized
is an empirical issue. What will be examined is whether incentive regulation in
the form of price caps has resulted in an improvement in productive efficiency.
The focus will be incumbent local exchange carriers. LECs are involved in three
different markets, where they produce identifiable outputs including local
service, intrastate toll/access service, and interstate access to local loops.
Incentive regulation, however, is applicable only to interstate access (both
common line and traffic-sensitive, switched access)[2]. Nevertheless, in order to
mitigate inferential problems associated with any observable change in
productive efficiency, it is necessary to consider all of the outputs in concert.
Productivity is just the ratio of output to input. Productivity changes due to
differences in production technology, differences in the efficiency of the
production process, and differences in the environment in which production
takes place. The problem is to attribute productivity variation to these sources
and an unattributed residual ± Abramovitz's (1956) famous ``measure of our
ignorance''. Solow (1956) sought to attribute output growth to input growth and
technical change by distinguishing movements along a production frontier
from shifts in the frontier. Economies of scale were added to the explanation by
Brown and Popkin (1962). David and van de Klundert (1965) allowed technical
change to be biased. The effects of scale economies and technical change on
productivity growth were translated into their effects on production costs by
Ohta (1974) and Binswanger (1974). Only Nishimizu and Page (1982), who
decomposed productivity into shifts in the production frontier and movements
toward or away from it, attempted to incorporate efficiency change into a
model of productivity change.
The ability to include efficiency change as a component of productivity
change depends on the data that are available and on the assumptions that
must be made. A credible assessment of the role of efficiency change in
productivity change requires a pooling of cross-sectional and time series data
(Lovell, 1993).
In the analysis designed to measure the productive efficiency of a
multiproduct firm, there are two commonly used approaches[3] ±
the mathematical programming approach and the econometric approach[4]. The
mathematical programming approach is known as data envelopment analysis
Journal of (DEA). Drawing on the work of Debreu (1951) and Koopmans (1951), Farrell
Economic (1957) argued that it is practical to measure productive efficiency based on a
Studies production possibility set consisting of the conical hull of input-output vectors.
This framework was generalized to multiple outputs and reformulated as a
29,2 mathematical programming problem by Charnes et al. (1978). The DEA
approach does not require any assumptions about the functional form. The
154 efficiency of a LEC is measured relative to all other LECs with the simple
restriction that all LECs lie on or below the efficient frontier.
In the programming method, DEA ``floats a piece-wise linear surface to rest
on the top of the observations'' (Seiford and Thrall, 1990, p. 8). The facets of the
hyperplane define the efficiency frontier, and the degree of inefficiency is
quantified and partitioned by a series of metrics that measure various distances
from the hyperplane and its facets (Leibenstein and Maital, 1992).
A couple of different econometric approaches to incorporating efficiency
change into a model of productivity growth, where there are multiple outputs,
and multiple inputs have been used (Greene, 1993). The majority of studies
have either aggregated the multiple outputs into a single index or modeled the
technology using a dual cost function. These studies require the imposition of a
number of restrictive assumptions including revenue maximization and/or
cost-minimizing behavior. The distance function approach which will be used
here requires no such set of assumptions.
A distance function is a functional representation of multiple-output,
multiple-input technology, which require data only on input and output
quantities. Hence, the measure of productivity change does not, unlike the
Tornqvist index, require data on cost or revenue shares to aggregate inputs
and outputs, yet is capable of measuring the change in total factor productivity
in a multiple-output setting (Fare et al., 1994a).
Following Shephard (1970), the output distance function is defined for time
period t as[5]:
dot …xt ; yt † ˆ inff : …xt ; yt =† 2 St g; …1†

where xt denotes the input vector, yt denotes the output vector, and St denotes
the production technology set that models the transformation of inputs, xt, into
outputs, yt.
This function is defined as the reciprocal of the maximum proportional
expansion of the output vector yt, given inputs xt. It completely characterizes
the technology. In particular dot (xt, yt)  1 if and only if (xt, yt) 2 St. In addition
dot (xt, yt) = 1 if and only if (xt, yt) is on the boundary or frontier of technology. In
the terminology of Farrell (1957), this occurs when production is technically
efficient.
It follows from the definition of the distance function, doi that it is non-
decreasing, positively linearly homogeneous of degree one in outputs and
convex in y, and decreasing in x. Additionally, it is the reciprocal of Farrell's
(1957) measure of output technical efficiency, which calculates how far an
observation is from the frontier of technology (Fare et al., 1994b).
 A variety of approaches have been used to estimate distance functions. Measuring the
These include data envelopment analysis, parametric deterministic linear change
programming (PLP), corrected ordinary least squares (COLS), and stochastic
frontier production function (SFP). A number of discussions and comparisons
of these approaches are available (e.g. Coelli and Perelman, 1996). In what
follows the corrected ordinary least squares approach will be used. The COLS
approach has the advantage of being fairly straightforward to estimate.
155
Additionally, it allows for conducting conventional hypothesis tests. Coelli
and Perelman (1999) conclude that COLS, parametric linear programming and
data envelopment analysis give consistent results. Their results suggest that
there is nothing to recommend strongly one approach over others that are
available.
A translog specification is used for the distance function. The functional
form for the distance function should be flexible, easy to estimate, and permit
the imposition of homogeneity (Coelli and Perelman, 2000). A translog
specification has been used successfully in a number of studies (e.g. Lovell et al.
(1994) and Grosskopf et al. (1997)).
The translog distance function for M outputs and K inputs is given as[6]:
X
M
ln doi ˆ a0 ‡ am ln ymi
mˆ1
X
M X
M
‡ 1=2 amn ln ymi ln yni
mˆ1 nˆ1
X
K
‡ bk ln xki …2†
kˆ1
X
K X
K
‡ 1=2 bkl ln xki ln xli
kˆ1 lˆ1
X
K X
M
‡ 1=2 ckm ln xki ln ymi ; i ˆ 1; 2; . . . ; N ;
kˆ1 mˆ1

where i denotes the ith firm in the sample. The time subscript t has been
suppressed.
To obtain the production frontier surface (i.e. transformation function), set
doi = 1. This implies that the left-hand side of Equation (2) is equal to zero.
The restrictions required for homogeneity of degree 1 in outputs are:
X
M
am ˆ 1; …3†
mˆ1
Journal of and
Economic X
M
Studies amn ˆ 0; m ˆ 1; 2; . . . ; M; …4†
29,2 mˆ1

and
156
X
M
ckm ˆ 0; k ˆ 1; 2; . . . ; K: …5†
mˆ1

The restrictions required for symmetry are:

amn ˆ anm ; m; n ˆ 1; 2; . . . ; M ; …6†

and
bkl ˆ blk ; k; l ˆ 1; 2; . . . ; K: …7†

A convenient approach for imposing the homogeneity constraint is to follow

Lovell et al. (1994) and observe that homogeneity implies:
do …x; y† ˆ do …x; y† for any > 0: …8†

Thus, one of the outputs can be arbitrarily chosen, such as the Mth output, with
= 1/ym to impose this constraint. Then:
do …x; y=ym † ˆ do…x; y†=ym : …9†

For a translog production function, imposition of the homogeneity restriction

translates into:
X1
M
ln …doi =ymi † ˆ a0 ‡ am ln ymi 
mˆ1
X1 M
M X1
‡ 1=2 amn ln ymi  ln yni 
mˆ1 nˆ1
X
K
‡ bk ln xki …10†
kˆ1
X
K X
K
‡ 1=2 bkl ln xki ln xli
kˆ1 lˆ1
X X1
K M
‡ 1=2 ckm ln xki ln ymi  ; i ˆ 1; 2; . . . ; N ;
kˆ1 mˆ1

where ymi = ymi/yMi.

 To simplify the COLS estimation, Equation (10) can be rewritten as: Measuring the
ln …doi =yMi † ˆ Translog…xi ; yi =yMi ; a; b; c†; i ˆ 1; 2; . . . ; N; …11† change
or
ln …doi † ln …yMi † ˆ Translog…xi ; yi =yMi ; a; b; c†; i ˆ 1; 2; . . . ; N ; …12†
157
and therefore as:
ln …yMi † ˆ Translog…xi ; yi =yMi ; a; b; c† ln…doi †; i ˆ 1; 2; . . . ; N : …13†

The objective of the COLS estimation is to obtain values of the parameters of

the translog function such that the function fits the data as closely as possible,
while maintaining the constraint that 0 < doi  1, which implies that
1 < doi  0.
Greene (1980) describes how corrected ordinary least squares can be used to
estimate an output distance function. The function is fitted in two steps. The
first step involves interpreting the unobservable term ±ln (doi) in Equation (13)
as a stochastic term and estimating the translog distance function using
ordinary least squares. In the second step, the ordinary least squares estimate
of the intercept term, a0, is adjusted by adding the largest negative ordinary
least squares residual, so that the function bounds the observed data points
from above. The distance measure for the ith firm is calculated as the exponent
of the corrected ordinary least squares residual.

Empirical implementation
Comprehensive and consistent LEC data are needed to measure the change in
productivity of LECs using a distance function specification. To minimize the
measurement errors introduced by the entry of new firms into the industry,
mergers of existing firms, etc., just the Regional Bell Operating Companies will
be used in the analysis[7]. Twelve time periods are considered covering 1988-
1999. Price caps for interstate access went into effect in 1991. Use of data before
this period and subsequent to this period will give an indication of whether
there has been an identifiable improvement in productive efficiency. The year
1988 is chosen as the earliest time period, because data-reporting requirements
changed in 1988. Use of earlier data would require making several ad hoc
assumptions to make the data conformable with data for 1988 and later, that
potentially serve to obfuscate the issue of interest. It also avoids the problem of
using data immediately post-divestiture. The period 1999 is chosen because it
is the most recent period for which the requisite data are available. In order to
give the best possible insight into productivity change, the greatest level of
disaggregation of the requisite data publicly available is used. Thus, while
there are currently four Regional Bell Operating Companies, data are available
for 19 individual LECs[8].
Journal of Output measures
Economic Local exchange carriers provide service in three different markets ± local
Studies service, intrastate toll/access service, and interstate access to local loops. For
these services, characterizing output is not a trivial undertaking. Output of
29,2 telephone service includes both access and use. Access and use, however, are
complicated by access and use externalities. The presence of these externalities
158 means that, contrary to what is typically presumed, preferences are
interdependent across subscribers. That is, as more users gain access to the
telephone, the utility of customers in the aggregate rises. These externalities
are exceedingly difficult to quantify and are not measured here. Additionally,
output comes in a variety of forms including type (station, person, collect, etc.),
time-of-day, day of week, distance and duration (Taylor, 1994).
Given these considerations and not dwelling on the complications[9], three
different outputs measures are used ± the number of local dial equipment
minutes[10], the number of intraLATA billed access minutes for interstate
calls, and the number of interLATA billed access minutes for intrastate
calls[11]. Data on the first series were obtained from the public filings with the
Federal Communications Commission of the Regional Bell Operating
Companies. Data on the second two series were taken from the Statistics of
Communications Common Carriers (Federal Communications Commission
(various)).

Input measures
Based primarily on data availability issues, five separate inputs are considered,
including labor, three different types of capital, and materials.
The measure of the quantity labor is based on annual accounting data for
the number of employees from the Federal Communications Commission's
Statistics of Communications Common Carriers. Since there is no objective way
to account for the contribution of part-time versus full-time employees, just the
total number of employees is used as the labor input measure. This, however,
does not introduce a substantial bias in the labor quantity measure, since part-
time employees accounted for less that 0.7 percent of the workforce in 1998.
Three different measures of capital input are considered including central
office switching equipment, central office transmission equipment, and cable
and wire facilities. The primary sources of growth in LEC productivity are in
switching and in transmission. Hence, it is desirable to consider these
separately (Telecommunications Industry Association, 2000).
The starting-point for the compilation of data on capital input is the
measurement of the capital stock. The perpetual inventory method is employed
to estimate the level of each component of the capital stock (Goldsmith, 1951).
The perpetual inventory method is used to remove embedded inflation that
would distort the measurement of capital. The application of the perpetual
inventory model relies on Federal Communications Commission's depreciation
rates. Unadjusted capital addition data were obtained from the Statistics of
Communications Common Carriers (Federal Communications Commission Measuring the
(various)). change
A composite asset price index is needed. First, Bureau of Economic Analysis
asset prices were obtained from the National Income and Product Accounts
(NIPA). These included prices for three asset categories: communications
equipment, telecommunication structures, and a composite asset price for
producer durables. Capital additions data are then grouped into categories 159
corresponding to the NIPA asset categories, and each category's share
calculated.
Materials input quantity is derived by dividing materials expense by a
materials price index. Materials expense is just total operating expense minus
the sum of total labor compensation, depreciation and amortization expense.
The materials price index was obtained from the Bureau of Labor Statistics and
is based on materials purchases of communications industries.

Measuring productive efficiency of LECs

Before turning to the estimation results, a few details need to be addressed.
First, since the data begin in 1988 and price caps were adopted in 1991, it is
important to test whether there was any identifiable structural shift in the
distance function between the two periods, 1988-1990 and 1991-1999. In this
regard each of the parameters was considered separately and a variable
coefficient specification considered[12]. The results are voluminous and not
reproduced here. (They are available on request.) Just one of the estimated
coefficients indicated a structural change[13]. This is most likely a spurious
result.
Another issue of importance is whether the symmetry restrictions hold.
These restrictions were tested pairwise. As before, the results are voluminous
and not reproduced here but are available upon request. In no instance was the
null hypothesis of symmetry rejected at the 5 percent level.
The corrected ordinary least squares estimates of the parameters for Equation
(10) are presented in Table I. The homogeneity constraint was imposed by
dividing the number of intraLATA billed access minutes for interstate calls, y1,
and the number of interLATA billed access minutes for intrastate calls, y2, by the
number of local dial equipment minutes, y3. Recall that the inputs include three
measures of capital input including central office switching equipment, x1,
central office transmission equipment, x2, and cable and wire facilities, x3, labor,
x4, and materials, x5. The computed coefficients resulting from the imposition of
the homogeneity constraints are not reported. Their calculation is
straightforward.
The estimation results are well behaved ± the estimates being fairly
robust[14] and the data fit the specification satisfactorily with a coefficient of
determination in excess of 0.99. The first-order input coefficients sum to a value
greater than one, suggesting the presence of increasing returns to scale at the
mean. When used in conjunction with the standard errors of the estimates,
however, it is not possible to reject the null hypothesis of constant returns to
Journal of Coefficient Coefficient estimate Standard error
Economic
Studies a0 ±0.1510 0.0392
a1 0.1281 0.0518
29,2 a2 0.6176 0.2715
a11 ±0.1573 0.0439
a12 0.1956 0.0922
160 a13 0.1611 0.0323
b1 0.2738 0.0892
b2 0.5100 0.1531
b3 0.1319 0.0479
b4 0.1230 0.0529
b5 0.0894 0.0327
b11 0.7291 0.3311
b12 ±0.0016 0.0271
b13 ±0.0879 0.0316
b14 0.1399 0.0555
b15 0.0027 0.0009
b22 ±0.0841 0.0449
b23 0.0661 0.0517
b24 ±0.1915 0.0772
b25 0.0545 0.0251
b33 ±0.1823 0.0870
b34 0.1001 0.0271
b35 ±0.0769 0.0425
b44 0.6517 0.2278
b45 ±0.0673 0.0514
b55 ±0.1754 0.0656
c11 ±0.0882 0.0319
c21 0.0618 0.0114
c31 0.0366 0.0319
c41 0.0856 0.0318
c51 0.0027 0.0019
c12 0.0564 0.0107
c22 0.0971 0.0454
c32 ±0.0091 0.0191
c42 ±0.0416 0.1174
Table I. c52 0.0080 0.0077
Parameter estimates for
the distance function Notes: Log of the likelihood function = 33.462; R2 = 0.9950

scale at the 5 percent level. The second-order cross-product terms, a12 and a13,
have the correct signs required for the transformation function to have a
concave shape.

Technical efficiency of production

Estimation of the distance function permits computation of the technical
efficiency of production of individual LECs via relationship (10). Results of this
computation are reported in Table II. Before discussing these results, it is
important to reiterate that the efficiency measure relates to the combined
 Technical efficiency Measuring the
LEC 1988-1990 1991-1999 change
Illinois Bell Telephone Company 0.7119 0.0148 0.6910 0.0564
Indiana Bell Telephone Company 0.7435 0.0553 0.7922 0.0727
Michigan Bell Telephone Company 0.7869 0.0138 0.7452 0.0379
The Ohio Bell Telephone Company 0.8065 0.0116 0.7606 0.0595
Wisconsin Bell, Inc. 0.7021 0.0145 0.6514 0.0634
161
Bell Atlantic ± Delaware, Inc. 0.7662 0.0150 0.7052 0.0271
Bell Atlantic ± Maryland 0.7694 0.0504 0.8001 0.0310
Bell Atlantic ± New England Telephone
and Telegraph Company 0.7315 0.0119 0.7548 0.0388
Bell Atlantic ± New Jersey, Inc. 0.6778 0.0400 0.7003 0.0499
Bell Atlantic ± New York Telephone Company 0.7505 0.0265 0.7831 0.0526
Bell Atlantic ± Pennsylvania, Inc. 0.6743 0.0498 0.7524 0.0376
Bell Atlantic ± Virginia, Inc. 0.8108 0.0265 0.7976 0.0344
Bell Atlantic ± Washington, DC, Inc. 0.7761 0.0178 0.7447 0.0175
Bell Atlantic ± West Virginia, Inc. 0.8297 0.0022 0.9019 0.0654
BellSouth Telecommunications, Inc. 0.7115 0.0171 0.7826 0.0529 Table II.
Nevada Bell 0.7695 0.0639 0.7257 0.0594 Average technical
Pacific Bell 0.8251 0.0155 0.7476 0.0484 efficiency for LECs:
Southwestern Bell Telephone Company 0.7472 0.0411 0.7701 0.0298 1988-1990 and 1991-
US West Communications, Inc. 0.7856 0.0365 0.7240 0.0508 1999

provision of three services provided by LECs including local service, intrastate

toll/access service, and interstate access to local loops.
Two separate time periods are considered ± 1988-1990 and 1991-1999. This
is done in order to determine whether there has been any identifiable change in
technical efficiency in response to the implementation of price caps. For
individual LECs, the mean values of technical efficiency used in conjunction
with the standard deviations for the two periods indicate that for none of the
LECs was there a change in technical efficiency in response to the adoption of
price caps. This, as noted previously, is something that incentive regulation in
the form of price caps was designed to encourage.
For the 1991-1999 period, technical efficiency ranges from a low of 0.65
(Wisconsin Bell, Inc.) to a high of 0.90 (Bell Atlantic ± West Virginia, Inc.). The
variability across LECs, however, in technical efficiency is relatively modest.
There is no discernible trend between LECs as to why one has a slightly better
technical efficiency measure than another.
The absence of any identifiable change in technical efficiency has a number
of possible explanations. For example, while total factor productivity increased
over the 1988-1999 period (Uri, 2000), this growth most likely was due to
innovation rather than to improvements in technical efficiency. Relatively large
increases in investment in both central office switching equipment and cable
and wire facilities were made over this period. In the case of switching
equipment, major investments were made, for example, in frame relays[15] and
ATM[16]. For cable and wire facilities, substantial investments were made in
Journal of optical fiber[17]. The increase in the demand for access to the Internet as well as
Economic the need by businesses to transfer large amounts of data have driven the
Studies growth in investment designed to transfer higher levels of bandwidth at faster
rates (Telecommunications Industry Association, 2000). This investment did
29,2 not translate into technical efficiency improvements.

162 Comparison
How do the results obtained here compare with similar studies of industries
subject to incentive regulation? Unfortunately, there is a dearth of studies that
specifically look at the technical efficiency impact of incentive regulation in the
telecommunications industry[18]. There are just a few such studies. Tardiff and
Taylor (1993) test whether it affects the rate of total factor productivity growth
over time[19]. Measuring total factor productivity using the conventional
growth accounting approach[20], they pool cross-section and time series data
over the period 1984 to 1990 for large LECs in the USA. They conclude that
incentive regulation increases annual productivity growth by about 2.8 percent.
This increase in productivity is driven equally by higher output and lower
input growth. Tardiff and Taylor also find that LECs that operate under
incentive regulation are able to produce the same output with about 6 percent
less labor than LECs that do not operate under incentive regulation.
Another study that explicitly looks at the effect of incentive regulation on
LEC productivity is that by Majumdar (1997)[21]. Using data envelopment
analysis based on three outputs and three inputs for the period 1988 to
1993[22], Majumdar finds that price caps plans as a replacement for rate of
return regulation have a marginally statistically significant positive, but
lagged, effect on the technical efficiency of local exchange carriers. It is claimed
that the impact of price caps on scale efficiency is positive, although the
reported results are only marginally statistically significant. For neither
technical efficiency nor scale efficiency are the effects of price caps on
productivity quantified.
One final study examining the effects of incentive regulation on productivity
is that by Resende (2000). This study is very similar to that of Majumdar, using
three inputs and three outputs for the period 1988 to 1993 and focusing just on
the impact of incentive regulation on local telephony productivity[23]. Resende
finds that, after correcting for technological change, incentive regulation does
lead to a higher level of technical efficiency[24].

Conclusion
Incentive regulation in the telecommunications industry in the USA adopted in
1991 was designed as an incentive to improve the productive efficiency of local
exchange carriers. After providing an overview of the nature of incentive
regulation and its desirable properties, a methodology for measuring technical
inefficiency and its change is introduced. This is a distance function approach
measuring technical efficiency. It is capable of representing multiple outputs
and multiple inputs. A translog specification is adopted for the distance
function. In implementing the approach, data on three outputs and five inputs Measuring the
for 19 local exchange carriers covering the period 1988-1999 are used. The change
results of implementing this approach suggest that, in the production of local
service, intrastate toll/access service, and interstate access to local loops, there
was no identifiable change in technical efficiency between the 1988-1990 period
and the 1991-1999 periods, something that incentive regulation was specifically
designed to enhance. Finally, an assessment of technical efficiency across 163
individual LECs in the USA indicates little variability.
Notes
1. Section 61.45 (b) of the Commission's rules.
2. Interstate access service has grown much more rapidly on average than demand for local
service and intrastate access service. The data on this are clear. Thus, in the presence of
economies of density, there is every reason to expect that productivity enhancements
experienced historically in the interstate access market would be substantially greater than
the overall rate of productivity growth experienced by LECs in supplying all services (Shin
and Ying, 1993). Most of the productivity growth experienced in the telecommunications
industry is related to reductions in switching costs and to savings in transmissions costs,
which occur as a result of using electronics to expand the carrying capacity of
transmissions facilities. In contrast productivity growth in supplying loop services has
been relatively lower.
3. There are other approaches including the conventional growth accounting approach and
the index number approach. These are not considered here, because they implicitly assume
productive efficiency for each time period and hence provide no insight into the issue of
interest (Grosskopf, 1993).
4. These two approaches are sometimes referred to as the non-parametric and the parametric.
5. The subscript ``o'' is introduced to emphasize the fact that this is an output-oriented
specification. An input-oriented specification can be defined in an analogous fashion
(Grosskopf, 1993; Coelli and Perelman, 2000).
6. Observe that ln denotes the natural logarithm (log to the base e).
7. The Regional Bell Operating Companies are holding companies. Each Regional Bell
Operating Company owns two or more Bell Operating Companies. These Bell Operating
Companies correspond closely to the original 22 local phone companies that the Justice
Department divested from AT&T in 1984. A few of the local phone companies (e.g.
Southern Bell Telephone Company and South Central Bell Telephone Company combined
into simply BellSouth) have lost their pre-divestiture identities (Dodd, 1998; Newton, 1999).
This is reflected in the data that are available.
8. The 19 LECs are Illinois Bell Telephone Company, Indiana Bell Telephone Company,
Michigan Bell Telephone Company, The Ohio Bell Telephone Company, Wisconsin Bell,
Inc., Bell Atlantic ± Delaware, Inc., Bell Atlantic ± Maryland, Bell Atlantic ± New England
Telephone and Telegraph Company, Bell Atlantic ± New Jersey, Inc., Bell Atlantic ± New
York Telephone Company, Bell Atlantic ± Pennsylvania, Inc., Bell Atlantic ± Virginia, Inc.,
Bell Atlantic ± Washington, DC, Inc., Bell Atlantic ± West Virginia, Inc., BellSouth
Telecommunications, Inc., Nevada Bell, Pacific Bell, Southwestern Bell Telephone
Company, and US West Communications, Inc.
9. For example, one complication involves how telephone service is priced (i.e. flat rate versus
measured service for local calls) and hence what is the appropriate measure of output. Note
that flat rate service is service whereby, for a fixed amount per month, the customer is
given a plain old telephone (POT) and is permitted an unlimited number of calls. With
Journal of measured service, the monthly charge is based on the number of calls, the time of day, the
distance traveled, and the length of the call.
Economic
10. Dial equipment minutes are the number of minutes a local exchange carrier's switch is
Studies used for handling calls.
29,2 11. IntraLATA calls are calls that originate and terminate in the same local access and
transport area (LATA). An interLATA call is one that is placed within one LATA and
164 received in a different LATA. LATA, also called service area by some Bell Operating
Companies, is one of 196 local geographical areas in the USA within which a local
telephone company may offer telecommunications services (Newton, 1999).
12. The coefficient for 1991 and later was allowed to be different from the 1988-1990
coefficient. This was accomplished by introducing an appropriate qualitative (dummy)
variable.
13. The coefficient c21 (input/output combination of central office switching equipment and the
number of intraLATA billed access minutes) showed a slight (5 percent) decline.
14. Ancillary analyses looked at different sample configurations and variable definitions.
These analyses yielded results consistent with those reported here.
15. Frame relay services employ a form of packet switching. The packets are in the form of
frames which are variable in length.
16. Asynchronous transfer mode (ATM) is a high bandwidth, low-delay, connection-oriented,
packet-like switching and multiplexing technique.
17. Fiber optics is a technology whereby electrical signals are converted into optical signals
that are transported through glass fiber and then reconverted by receivers at the other end
into electrical signals.
18. A generic review of studies on the effects of incentive regulation is provided by Kridel et al.
(1996).
19. Tardiff and Taylor (1993) look at productivity gains associated with local (intraLATA) toll
calls. The concern of the analysis in this paper is with interLATA (long distance) calls. A
LATA is a local access and transport area. A number of states implemented price cap
plans for local toll calls before they were implemented by the FCC for long-distance calls.
Tardiff and Taylor rely on state-level data for their analysis.
20. Uri (2000) examines the shortcomings associated with using the conventional growth
accounting approach for total factor productivity in the telecommunications industry.
21. This study is an update of Majumdar (1995).
22. The outputs consist of the number of local calls, the number of intrastate toll calls, and the
number of interstate calls. There are significant limitations associated with these output
measures and discussed in Appendix B (The 1999 Staff TFP Study by Noel D. Uri) in
Further Notice of Proposed Rulemaking, CC Docket No. 94-1, released November 15, 1999.
The major problem is that they do not accurately portray the growth in LEC output. Inputs
consist of switches, number of lines, and number of employees. These measures of inputs
also suffer limitations, because they do not account for all LEC inputs. An extended
discussion of the appropriate output and input measures to use in measuring LEC
productivity can be found in Comments and Reply Comments to CC Docket No. 94-1, filed
in January 2000. These, as noted previously, can be accessed via the Federal
Communications Commission Web site.
23. The output measures are deflated revenue data. The input measures are total number of
employees, the total number of access lines, and the total number of central office switches.
The output and input measures are subject to the same criticisms noted in the Majumdar
study (1995) (see Note 21).
24. Another serious shortcoming with the Resende analysis is the way the regulatory regime Measuring the
variable is defined and used. For a given state, it is defined simply as the number of
months in a year that an alternative form of regulation was in place. This is not change
satisfactory, because implementation of incentive regulation schemes between states is so
variable and takes on such individual characteristics that they cannot be effectively
portrayed by such a simple scheme. This issue is more fully explored in Isaac (1991) and
Noam (1991).
165
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