The cost-based regulation of telecommunications (e.g.,rate of return regulation) had significant negative effects on innovation while it was claimed that it led to excessive capital investment. Most experts agree that cost-based regulation led to significant consumer harm. During the 1980s price cap regulation was implemented instead of cost-based regulation in most advanced countries. Price cap regulation has important economic incentive attributes for innovation and investment in networks by the incumbunt firms in telecommunications.
During the 1990s cost-based regulations has reappeared because of the necessity to set prices for unbundled network elements sold by the incumbent firms to their competitors. Unfortunately the adoption of TELRIC as a cost basis to set the prices for unbundled elements has negative economic incentive effects for innovation and for new investment in telecommunications networks.
Regulator`s failure to recognize the sunk cost character of much network investment leads to the grant of a free option to the competitors of the incumbent. Causing the shareholders of the incumbent firm to fund the free option for the competition will lead to underinvestment. Given the amount of uncertainty in a dynamic industry with rapidly changing technology and economics, this misguided regulatory policy can have an especially large effects on investment incentives because the value of real option is high.
This paper also shows that the long run incremental cost model have methodological flaws as it does not consider the effects of real option on its calculation. Policymakers are ill advised to use these cost models to determine USOs, UNEs, or interconnection charges. The magnitude of the error can result in hundreds of millions of misallocated resources. Incorrect price signal will retard investment, research and development. The mis-estimation can equally cost consumers hundreds of millions in lost welfare. It would be highly irresponsible for policymakers to make decisions without considering real option impacts. Policies dealing with costs cannot be effective unless they are made with a fundamental understanding of the real option theory`s implications.
