Interconnection and incentive regulation in network industries

The price regulation of network industries has changed tremendously all over the world recently. Theoretical contributions specifically advocate and telecommunications, energy and other market regulators in various parts of the world practice cost-based pricing for inter-firm network access services. Cost-based pricing is performed under the assumption that the regulator has perfect information regarding the costs of producing the services. We show that — under fairly general conditions — cost-based pricing creates incentives for regulated firms not to improve their efficiency. Allowing for information asymmetry between the regulator and the regulated firms, we find that incentive regulation will eliminate the adverse effect of cost-based pricing on the firms’ efficiency and on social welfare.