TELRIC Pricing with Vintage Capital

Abstract

This paper studies the effect of technical progress on competitive equilibrium prices in a formal dynamic setting that includes the dynamic effects of business income taxes. The model is designed to facilitate comparison between competitive equilibrium prices and the TELRIC prices that were recently adopted by the FCC for determining universal service subsidies in telecommunications. The equilibrium prices differ from the regulatory prices due to 1) differences in discount factors, 2) differences in the stream of operating costs, and 3) differences in the discounting method applied to the revenue stream. In a calibrated comparison of prices for end-office switching services, we find that the last difference is the most important, and the net effect of these differences is regulated prices that understate competitive equilibrium prices by billions of dollars nationwide in present value terms. We also note that equilibrium prices can be derived without making any assumptions about depreciation methods, contrary to conventional regulatory practice, and that competitive prices cannot be calculated in advance of costs once capital utilization is endogenized.