The effect of sunk costs in telecommunications regulation

Abstract

Under the Telecommunications Act of 1996, the FCC mandated forward looking cost-based prices for competitors to use unbundled local exchange company (LEC) facilities. The FCC does not permit any markup over cost to allow for the risk associated with investment in sunk assets; instead, it uses a total service long-run incremental cost (TSLRIC) type approach that attempts to estimate TSLRIC on a forward looking basis. TSLRIC allows for the recovery of the cost of investment and variable costs of providing the service over the economic lifetime of the investment. However, TSLRIC makes no allowance for the sunk and irreversible nature of telecommunications investment, so that it adopts the perfect contestability standard. This standard provides incorrect economic incentives for efficient investment once technological and economic uncertainty exist along with sunk investments. Equivalently, FCC regulation requires incumbent LECs to give a free option on the use of their sunk investment in network facilities to new entrants. Thus, the FCC has chosen the incorrect standard for setting regulated prices, which will be below the correct economic cost of the network investments. TSLRIC will lead to less innovation and decreased investment below economically efficient levels. Decreased consumer welfare will be the result of the FCC’s policy.