Economic Report of the President

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Traditional, Rate-of-Return RegulationUnder traditional, rate-of-return regulation, the regulator estimates the firm’scapital base and incremental cost. This approach allows the firm to charge pricesjust high enough to yield a rate of return that would have attracted capital tothe industry, had the industry been open to competitive entry.The traditional approach to regulation presents several difficulties. First,measuring a firm’s capital base and incremental cost involves substantialauditing effort and uncertainty for the regulator. Judging the appropriate rateof return is also difficult, as it involves gauging the riskiness of capital investmentsin the industry. An especially problematic aspect of traditionalregulation, though, is its effect on incentives. A firm in a competitiveindustry, and even an unregulated monopolist, has an incentive to trim itscosts to a minimum so that it can capture the highest possible profit. A firmsubject to rate-of-return regulation has no comparable incentive to keep costsdown. The higher the firm’s incremental costs, the higher the prices the regulatorwill generally allow the firm to charge to cover those costs. A keyproblem is that the firm has an incentive to choose overly capital-intensivetechnologies, because this increases the capital base to which the regulatorapplies the firm’s allowable rate of return.Price-Cap RegulationMany Federal and state regulators have turned from traditional regulation toprice-cap regulation of industries considered to be natural monopolies. Priorto 1984, all states regulated telephone service on a rate-of-return basis. BySeptember 2004, 37 states had switched to some form of price-cap regulation.Under price-cap regulation, the regulator sets an initial price or basket of pricesthat the firm can charge for its goods. The price caps are then updated overtime, by a positive factor to account for inflation and a negative offset toaccount for the firm’s perceived ability to trim its costs through productivityimprovements. If the regulated firm succeeds in trimming costs by more thanthan the productivity offset in the price cap, its profits will increase. The hopeis that price-cap regulation may avoid some of the perverse incentive effects oftraditional regulation, by de-linking the regulated firm’s returns from itscosts. Several recent studies have found that, in comparison with rate-of-returnregulation, price-cap regulation is associated with improvements in the technicalefficiency of telecommunications providers, as well as greater investmentin modernizing switches and deploying fiber-optic cable.Price-cap regulation is far from ideal, however, and in fact faces problemssimilar to those of traditional regulation. In setting the initial price cap, theregulator must measure the firm’s capital base and incremental costs, as wellas determine a rate of return that the capped prices should yield. This is identicalto the process in traditional rate-of-return regulation. In setting an144 | Economic Report of the President
inflation factor for the price cap’s growth, the regulator must assess both therate at which the firm’s input costs are likely to grow and the rate of productivitygrowth the firm is capable of achieving. Given difficulties in gaugingthese rates, the regulator must make periodic adjustments to the price-capmechanism in light of industry outcomes. But if the regulated firm underperforms,is it because the regulator miscalculated, or because the firm failed topursue productivity improvements diligently?Both rate-of-return and price-cap regulation suffer to some degree frominformation problems. A regulator cannot know with precision all of theeconomic factors relevant to setting prices. In practice, these types of regulationcan lead to shortages, high costs, slowed innovation, or a combination ofall of these shortcomings. Where vigorous competition is feasible, marketforces can guide firms to deploy their resources in ways that benefit customersfar more effectively than could a price-setting regulator.Advancing technology is providing competitive inroads to a number ofindustries once considered natural monopolies. Satellite television offers acompetitive alternative to cable television service (Box 6-2), and wirelesstelecommunications are competing with wireline telephone services. Suchtechnology-induced competition can be expected to increase as cable companiesbegin to offer voice communications and telephone companies roll outvideo services.Box 6-2: Satellite TelevisionVirtually all cable system operators hold franchise monopolies overcable television service within their local service territories. Only a fewcommunities have issued multiple franchises, allowing for “overbuild”competition between cable system operators in the local market. Anumber of studies have found that cable rates in the 1980s wereroughly 20 percent lower in markets with cable overbuild competitionthan in comparable markets served by cable franchise monopolists.The rise of satellite TV services since the mid-1990s has also putcompetitive pressure on cable system operators. A study of thousands ofcable systems across the United States finds that, controlling for a varietyof other factors, a cable system’s penetration rate (cable subscribers as aratio of homes passed by cable) tends to be lower in areas where satellitereception is better. This is consistent with satellite TV providing morecompetition to cable TV where a larger fraction of households has accessto satellite reception. While satellite TV has taken market share away fromcable TV, the overall penetration of pay TV services among U.S. householdshas grown as satellite TV services have grown. As of June 1998,78 percent of households with televisions subscribed to pay TV service.Chapter 6 | 145
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Economic Reportof the PresidentTran
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C O N T E N T SECONOMIC REPORT OF T
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ECONOMIC REPORT OF THE PRESIDENTTo
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the playing field is level for our
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LETTER OF TRANSMITTALCOUNCIL OF ECO
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Monetary Policy ...................
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Encouraging FDI ...................
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3-4. The Equivalence of Sales Taxes
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Real GDP expanded by 3.7 percent du
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Options for Tax ReformChapter 3, Op
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and better Nation for it. A compreh
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Innovation and the Information Econ
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ecause they do not expect family me
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The Administration has pushed aggre
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C H A P T E R 1The Year in Review a
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Consumer SpendingConsumer spending
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easons for this correlation are dis
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2003, a number of countries that to
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ProductivityRecent productivity gro
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The projected path of inflation as
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strengthen. The forecast is based o
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The growth rate of the economy over
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In sum, potential real GDP is proje
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C H A P T E R 2Expansions Past and
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The behavior of real GDP is similar
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of faltering may be attributable to
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most recent expansions have shown r
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middle of 2003. The more moderate r
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1.2 percent. Employment continued t
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SummaryModerate recessions are foll
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permanent cuts should permanently r
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and the Jobs and Growth Tax Relief
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Federal government revenues had bee
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Fiscal policy played an especially
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C H A P T E R 3Options for Tax Refo
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High Compliance CostsThe complexity
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a reasonable estimate is that a 10
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Excess BurdenBecause taxes distort
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Box 3-3 — continuedThe bottom 40
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more uniform or pure version of the
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of being collected all at once at t
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would have to differ from state tax
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owner claimed it was for business,
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The current set of saving incentive
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the current system. In addition, so
Page 91 and 92: C H A P T E R 4ImmigrationIn recent
Page 93 and 94: TABLE 4-1.— Foreign-Born Share of
Page 95 and 96: immigrants (also called illegal or
Page 97 and 98: largest group of immigrants was bor
Page 99 and 100: employment costs, including wage fl
Page 101 and 102: Chapter 4 | 103
Page 103 and 104: wages fall in response to immigrati
Page 105 and 106: immigrants from Latin America do re
Page 107 and 108: addition, as migrants leave the cou
Page 109 and 110: include siblings and adult children
Page 111 and 112: despite the tremendous growth in th
Page 113 and 114: The TWP would allow new foreign wor
Page 115 and 116: C H A P T E R 5Expanding Individual
Page 117 and 118: This phenomenon, known as the “tr
Page 119 and 120: producing more of that good. Simila
Page 121 and 122: In 2002, the President proposed “
Page 123 and 124: provide evidence of increased profi
Page 125 and 126: schools are four times as efficient
Page 127 and 128: low administrative costs, estimated
Page 129 and 130: Box 5-2: The Benefits of Land Title
Page 131 and 132: development plan designed by others
Page 133 and 134: C H A P T E R 6Innovation and theIn
Page 135 and 136: E-mail is the most common online ac
Page 137 and 138: Changed circumstances, such as new
Page 139 and 140: Illegal Acts on the InternetThe Int
Page 141: or develop new markets, which can l
Page 145 and 146: U.S. households connecting to local
Page 147 and 148: garbling their transmissions. To li
Page 149 and 150: from 51.3 percent in December 1999
Page 151 and 152: for their property rights. The Admi
Page 153 and 154: C H A P T E R 7The Global HIV/AIDS
Page 155 and 156: Chart 7-1 Estimated HIV Infection L
Page 157 and 158: There is no cure for HIV/AIDS, thou
Page 159 and 160: AIDS is more damaging to a househol
Page 161 and 162: and risk reduction have helped redu
Page 163 and 164: only one price, the drug companies
Page 165 and 166: Box 7-1 — continuedfocused on the
Page 167 and 168: Box 7-2 — continuedenhancing coor
Page 169 and 170: ConclusionThe United States and cou
Page 171 and 172: Good Two. In Ricardo’s simple mod
Page 173 and 174: The Impact of Trade on Labor Market
Page 175 and 176: The U.S. Advantage in Services Trad
Page 177 and 178: U.S. firms is associated with a cor
Page 179 and 180: anked the second-best country out o
Page 181 and 182: the Chinese government agreed to el
Page 183 and 184: Trade LiberalizationTariffs and oth
Page 185 and 186: ConclusionThe United States is the
Page 187 and 188: LETTER OF TRANSMITTALCOUNCIL OF ECO
Page 189 and 190: Report to the President on theActiv
Page 191 and 192: The Council continued its efforts t
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The Staff of the Council of Economi
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John List and Ted Gayer provided co
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Appendix BSTATISTICAL TABLES RELATI
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PageB-32. Gross saving and investme
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PageB-94. Relation of profits after
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NATIONAL INCOME OR EXPENDITURETABLE
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TABLE B-2.—Real gross domestic pr
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TABLE B-3.—Quantity and price ind
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TABLE B-5.—Contributions to perce
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TABLE B-6.—Chain-type quantity in
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TABLE B-7.—Chain-type price index
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TABLE B-8.—Gross domestic product
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TABLE B-10.—Gross value added by
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TABLE B-12.—Gross domestic produc
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TABLE B-13.—Real gross domestic p
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TABLE B-14.—Gross value added of
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TABLE B-16.—Personal consumption
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TABLE B-18.—Private fixed investm
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TABLE B-20.—Government consumptio
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TABLE B-22.—Private inventories a
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TABLE B-24.—Foreign transactions
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TABLE B-26.—Relation of gross dom
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TABLE B-28.—National income by ty
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TABLE B-29.—Sources of personal i
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TABLE B-30.—Disposition of person
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Year or quarterTABLE B-32.—Gross
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TABLE B-33.—Median money income (
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TABLE B-35.—Civilian population a
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TABLE B-36.—Civilian employment a
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TABLE B-38.—Unemployment by demog
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TABLE B-40.—Civilian labor force
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TABLE B-42.—Civilian unemployment
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TABLE B-44.—Unemployment by durat
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TABLE B-46.—Employees on nonagric
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TABLE B-47.—Hours and earnings in
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Year orquarterTABLE B-49.—Product
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PRODUCTION AND BUSINESS ACTIVITYTAB
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Year ormonthTABLE B-53.—Industria
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Year or monthTABLE B-55.—New cons
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TABLE B-57.—Manufacturing and tra
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TABLE B-59.—Manufacturers’ new
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Year ormonthTABLE B-61.—Consumer
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TABLE B-62.—Consumer price indexe
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TABLE B-64.—Changes in consumer p
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TABLE B-65.—Producer price indexe
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TABLE B-67.—Producer price indexe
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TABLE B-68.—Changes in producer p
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TABLE B-70.—Components of money s
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TABLE B-71.—Aggregate reserves of
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TABLE B-73.—Bond yields and inter
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TABLE B-74.—Credit market borrowi
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TABLE B-75.—Mortgage debt outstan
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TABLE B-77.—Consumer credit outst
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TABLE B-79.—Federal receipts, out
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TABLE B-81.—Federal receipts, out
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TABLE B-83.—Federal and State and
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TABLE B-85.—State and local gover
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End of yearor monthTABLE B-87.—U.
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End of monthTABLE B-89.—Estimated
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TABLE B-91.—Corporate profits by
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TABLE B-93.—Sales, profits, and s
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YearComposite(Dec. 31,2002=5,000) 3
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YearAGRICULTURETABLE B-97.—Farm i
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TABLE B-99.—Farm output and produ
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Year ormonthTABLE B-101.—Agricult
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INTERNATIONAL STATISTICSTABLE B-103
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TABLE B-104.—U.S. international t
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TABLE B-106.—U.S. international t
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TABLE B-108.—Industrial productio
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TABLE B-110.—Foreign exchange rat
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TABLE B-112.—Growth rates in real
show all

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