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Measuring Productivity Change for Regulatory Purposes

Incentive regulation for some of the services provided by local exchange carriers in the U.S. telecommunications industry is based on price caps. Under price caps, a regulated firm's average real prices for services it provides are required to fall by a specified percentage each year. This percentage is known as the X-factor. An important component of the X-factor is productivity change for local exchange carriers providing interstate access service. Two separate approaches to measuring the change in productivity are considered. The total factor productivity approach (TFP), which is currently used in regulatory proceedings in the telecommunications industry, quantifies the change in output less the change in input and classifies it as the measure of productivity growth. There are a number of limitations with this approach. An alternative is proposed-the hybrid cost proxy model (HCPM)-which is an engineering process model that does not possess the limitations of the total factor productivity approach. The model combines engineering principles of design for the local loop, switching, and interoffice networks with economic principles of cost minimization. The two separate approaches are empirically implemented for Bell Atlantic, Inc.-Maryland for the period from 1985 to 1997. The results suggest that the realized productivity growth as measured by the total factor productivity approach is somewhat less than what would have been achieved had the network been optimally configured as indicated by the HCPM approach.