*Pages 1--75 from  Microsoft Word - 15837*
 Federal  Communications  Commission  FCC  99-  345
 1
 Before  the  Federal  Communications  Commission
 Washington,  D.  C.  20554
 In  the  Matter  of  )  )
 Price  Cap  Performance  Review  )  CC  Docket  No.  94-  1  for  Local  Exchange  Carriers  )
 )  Access  Charge  Reform  )  CC  Docket  No.  96-  262
 )
 FURTHER  NOTICE  OF  PROPOSED  RULEMAKING
 Adopted:  November  12,  1999  Released:  November  15,  1999
 Comment  Date:  December  30,  1999  Reply  Comment  Date:  January  14,  2000
 By  the  Commission:
 I.  INTRODUCTION
 1.  In  1997,  the  Commission  represcribed  the  amount  by  which  it  annually  adjusts  price  caps  for  incumbent  local  exchange  carriers  subject  to  the  price  cap  rules  ("  price  cap  LECs").  1  The  revised  price
 cap  adjustment  required  price  cap  LECs  to  reduce  inflation-  adjusted  prices  for  interstate  access  services  by  an  "X-  factor"  of  6.5  percent  annually.  Pursuant  to  petitions  for  review  of  the  Commission's  order,  the
 United  States  Court  of  Appeals  for  the  District  of  Columbia  Circuit  reversed  and  remanded  the  Commission's  decision.  2  The  court  has  stayed  issuance  of  its  mandate  until  April  1,  2000,  to  allow  time
 for  us  to  conduct  this  proceeding.  3
 2.  In  this  Notice  we  seek  comment  on  how  we  should  represcribe  an  X-  factor.  More  specifically,  we  seek  comment  on  prescribing  two  separate  X-  factors  to  address  retroactively  the  period
 affected  by  the  court  remand  (July  1,  1997  to  June  30,  2000),  and  prospectively  the  period  from  July  1,  2000  forward,  or  a  single  X-  factor  to  cover  the  combined  period.  Further,  we  seek  comment  on  resetting,
 on  a  forward-  looking  basis,  price  cap  LEC  prices  to  a  level  that  is  consistent  with  any  X-  factor  prescription  in  order  to  rebalance  the  sharing  of  benefits  of  price  caps  between  LECs  and  their  customers.
 1  Price  Cap  Performance  Review  for  Local  Exchange  Carriers,  Fourth  Report  and  Order  in  CC  Docket
 No.  94-  1  and  Second  Report  and  Order  in  CC  Docket  No.  96-  262,  12  FCC  Rcd  16642  (1997)  ("  1997  Price  Cap  Review  Order").
 2  USTA  v.  FCC,  188  F.  3d  521  (D.  C.  Cir.  1999).
 3  USTA  v.  FCC,  Nos.  97-  1469  et  al.,  (D.  C.  Cir.  June  21,  1999).
1
 Federal  Communications  Commission  FCC  99-  345
 2
 This  Notice  is  limited  to  issues  surrounding  the  setting  of  the  X-  factor,  and  does  not  include  any  broader  changes  to  our  method  of  price  cap  regulation.
 3.  We  seek  comment  on  represcribing  the  current  X-  factor  from  the  reasonable  range  determined  in  the  1997  Price  Cap  Review  Order.  4  In  the  alternative,  we  also  seek  comment  on
 represcribing  the  X-  factor  based  on  the  results  of  a  staff  study  of  the  rate  of  growth  in  total  factor  productivity  ("  TFP")  for  price  cap  LECs.  5  A  third  alternative  is  to  prescribe  an  X-  factor  based  on  the
 results  of  another  staff  study  which  directly  determines,  from  aggregate  interstate  expenses  and  revenues,  the  X-  factor  that  would  have  produced  a  competitive  level  of  capital  compensation  in  the  interstate
 jurisdiction  during  the  period  between  performance  reviews.  6  We  seek  comment  on  these  alternative  methods  for  represcribing  the  X-  factor.  We  also  seek  comment  on  whether  we  should  rely  on  one  of
 these  alternatives  to  prescribe  an  X-  factor  on  a  going-  forward  basis,  and,  if  so,  whether  we  should  use  data  from  the  same  time  period  as  for  the  period  affected  by  the  court's  remand.  In  addition,  we  seek
 comment  on  studies  submitted  in  the  record  that  propose  to  quantify  the  consumer  productivity  dividend  ("  CPD")  necessary  to  offset  the  elimination  of  sharing  requirements  from  the  price  cap  rules.
 4.  In  a  separate  but  related  proceeding,  the  Commission  is  seeking  comment  on  a  proposal  submitted  by  the  Coalition  for  Affordable  Local  and  Long  Distance  Services  ("  CALLS").  7  The  CALLS
 proposal  would  purportedly  eliminate  the  necessity  of  retrospectively  adjusting  the  X-  factor  in  response  to  the  court's  remand.  8  Instead,  it  would  keep  the  X-  factor  at  6.5  percent,  but  would  target  X-  factor
 reductions  to  the  traffic-  sensitive  price  cap  basket.  9  Once  local  switching  rates  reached  a  certain  level,  all  price  cap  indices  would  be  frozen.  10  Adoption  of  the  CALLS  proposal  would  also  eliminate  the  need  to
 prescribe  an  X-  factor  on  a  going-  forward  basis.  11  We  seek  comment  in  this  proceeding  on  the  prescription  of  the  X-  factor  because,  in  the  event  that  the  CALLS  proposal  is  not  adopted,  or  not  all  price
 cap  LECs  become  signatories  to  the  proposal,  the  Commission  must  be  prepared  to  prescribe  a  new  X-factor  before  April  1,  2000.
 4  1997  Price  Cap  Review  Order,  12  FCC  Rcd  at  16696-  97.
 5  See  infra  Section  III.  B;  Appendix  B.
 6  See  infra  Section  III.  C;  Appendix  C.
 7  See  Access  Charge  Reform,  Price  Cap  Performance  Review  for  Local  Exchange  Carriers,  Low-  Volume
 Long  Distance  Users,  Federal-  State  Joint  Board  on  Universal  Service,  Notice  of  Proposed  Rulemaking,  CC  Docket  Nos.  96-  262,  94-  1,  99-  249,  and  96-  45,  FCC  99-  235  (rel.  Sept.  15,  1999)  ("  CALLS  Notice").
 8  CALLS  Notice  at  App.  A    4.3.
 9  CALLS  Notice  at  App.  A    3.
 10  CALLS  Notice  at  para.  2,  and  App.  A    3.
 11  CALLS  Notice  at  App.  A    4.2.
2
 Federal  Communications  Commission  FCC  99-  345
 3
 II.  BACKGROUND
 A.  Prior  Commission  Decisions
 5.  The  Commission  has  determined  that  competition  should  be  the  model  for  setting  just  and  reasonable  LEC  rates  because:
 Effective  competition  encourages  firms  to  improve  their  productivity  and  introduce  improved  products  and  services,  in  order  to  increase  their  profits.  With  prices  set  by
 marketplace  forces,  the  more  efficient  firms  will  earn  above-  average  profits,  while  less  efficient  firms  will  earn  lower  profits,  or  cease  operating.  Over  time,  the  benefits  of
 competition  flow  to  customers  and  to  society,  in  the  form  of  prices  that  reflect  costs,  maximize  social  welfare,  and  efficiently  allocate  resources.  12
 In  1990,  the  Commission  determined  that  an  incentive-  based  price  cap  system  would  more  closely  represent  the  results  of  a  competitive  market  than  did  the  prior  regulatory  method  of  rate-  of-  return
 regulation.  13  Specifically,  the  price  cap  plan  was  "designed  to  mirror  the  efficiency  incentives  found  in  competitive  markets  .  .  .  by  encouraging  LECs  to  move  prices  for  interstate  access  services  to
 economically  efficient  levels,  to  reduce  costs,  to  invest  efficiently  in  new  plant  and  facilities,  and  to  develop  and  deploy  innovative  service  offerings."  14  In  order  to  promote  consumer  welfare  and  economic
 efficiency,  ceilings  were  set  on  prices  that  were  intended  to  allow  carriers  to  cover  their  costs  and  earn  a  normal,  competitive  rate  of  return.  If  prices  were  set  too  high,  consumers  would  fail  to  reap  the  benefits
 of  the  carriers'  efficiency;  if  prices  were  set  too  low,  the  return  on  capital  would  be  insufficient  to  attract  investment  into  the  industry.
 6.  Regulatory  structures  that  base  a  firm's  allowed  rates  directly  on  the  reported  costs  of  the  individual  firm  create  perverse  incentives,  because  reimbursing  the  firm's  costs  removes  the  incentive  to
 reduce  costs  and  improve  productive  efficiency.  The  Commission's  price  cap  plan  for  LECs  avoids  this  problem  in  part  by  divorcing  the  annual  rate  adjustments  from  the  performance  of  each  individual  LEC,
 and  in  part  by  adjusting  the  cap  for  experience  only  with  a  considerable  lag.  Individual  companies  retain  an  incentive  to  cut  costs  and  to  produce  efficiently,  because  in  the  short  run  their  behavior  has  no  effect
 on  the  prices  they  are  permitted  to  charge,  and  they  will  be  able  to  keep  any  additional  profits  resulting  from  reduced  costs.  The  introduction  of  LEC  price  cap  regulation  was  expected  to  stimulate  cost
 reduction  and  accelerate  technological  innovation  because  the  regulated  firms  would  be  able  to  benefit  from  such  behavior  as  they  could  not  do  under  rate-  of-  return  regulation.  15
 7.  To  achieve  these  goals,  the  Commission's  LEC  price  cap  scheme  allows  prices  to  increase  by  a  measure  of  inflation  minus  a  productivity  offset,  or  X-  factor.  The  X-  factor  represents  the  amount  by
 12  Price  Cap  Performance  Review  for  Local  Exchange  Carriers,  First  Report  and  Order,  CC  Docket  No.
 94-  1,  10  FCC  Rcd  8961,  9002  (1995)  ("  1995  Price  Cap  Review  Order").
 13  Policy  and  Rules  Concerning  Rates  for  Dominant  Carriers,  Second  Report  and  Order,  CC  Docket  No.
 87-  313,  5  FCC  Rcd  6786,  6789  (1990)  ("  LEC  Price  Cap  Order").
 14  1995  Price  Cap  Review  Order,  10  FCC  Rcd  at  8965.
 15  LEC  Price  Cap  Order,  5  FCC  Rcd  at  6789.
3
 Federal  Communications  Commission  FCC  99-  345
 4
 which  LECs  can  be  expected  to  outperform  economy-  wide  productivity  gains.  16  The  Commission  has  periodically  adjusted  the  LEC  price  cap  plan  to  ensure  that  it  continues  to  provide  strong  incentives  to
 incumbent  LECs  to  provide  a  substantial  benefit  to  customers,  while  not  basing  permitted  prices  explicitly  on  individual  firms'  costs.  17
 8.  The  X-  factor  adopted  in  the  LEC  Price  Cap  Order  initiating  price  cap  regulation  for  the  largest  LECs  included  an  additional  0.5  percent  consumer  productivity  dividend  ("  CPD")  to  ensure
 "direct  benefits  to  ratepayers."  18  The  CPD  was  included  to  account  for  an  expectation  that,  because  of  the  more  efficient  regulatory  scheme  being  adopted,  future  productivity  growth  would  be  faster  than
 measured  past  productivity  growth.
 9.  Initially,  price  cap  LECs  were  required  to  share  a  portion  of  their  earnings  in  excess  of  specified  rates  of  return  with  their  access  customers  by  temporarily  reducing  the  price  cap  ceiling  in  a
 subsequent  period.  19  In  1990,  the  Commission  prescribed  two  X-  factors;  a  minimum  3.3  percent  X-factor,  or  an  optional  4.3  percent  X-  factor.  20  Price  cap  LECs  that  opted  to  use  the  higher  X-  factor  were
 allowed  to  retain  larger  shares  of  their  earnings.  The  LEC  Price  Cap  Order  required  that  the  Commission  periodically  review  the  performance  of  the  price  cap  regime.  21  The  order  in  the  first  performance  review
 was  released  in  1995,  at  which  time  the  Commission  increased  the  minimum  X-  factor  from  3.3  percent  to  4.0  percent,  and  provided  two  optional  X-  factors  at  4.  7  and  5.  3  percent.  22  The  1990  and  1995
 prescriptions  were  derived  from  two  1990  staff  studies  that  examined  LECs'  historical  unit  cost  changes.  These  studies  did  not  utilize  a  total  factor  productivity  ("  TFP")  methodology.
 10.  In  the  next  performance  review  order,  released  in  1997,  the  Commission  further  revised  the  price  cap  plan  by  eliminating  all  sharing  requirements  and  prescribing  a  new  X-  factor  of  6.5  percent.
 This  X-  factor  prescription  relied  primarily  on  a  staff  study  of  the  historical  rate  of  growth  in  LEC  TFP  ("  1997  staff  TFP  study").  23
 11.  TFP  measurement  is  a  methodology  commonly  used  to  measure  productivity  and  productivity  growth  in  the  economy  as  a  whole.  24  Productivity  is  measured  as  the  ratio  of  an  index  of  the  outputs  of  a
 16  LEC  Price  Cap  Order,  5  FCC  Rcd  at  6796.
 17  See  LEC  Price  Cap  Order,  5  FCC  Rcd  at  6835.  See  also  1997  Price  Cap  Review  Order,  12  FCC  Rcd  at
 16707  .
 18  LEC  Price  Cap  Order,  5  FCC  Rcd  at  6796.
 19  LEC  Price  Cap  Order,  5  FCC  Rcd  at  6792.  For  a  complete  summary  of  the  original  price  cap  plan,  see
 LEC  Price  Cap  Order,  5  FCC  Rcd  at  6787-  89.
 20  LEC  Price  Cap  Order,  5  FCC  Rcd  at  6787.  These  amounts  included  the  CPD.
 21  LEC  Price  Cap  Order,  5  FCC  Rcd  at  6789.
 22  1995  Price  Cap  Review  Order,  10  FCC  Rcd  at  9055-  56.  These  amounts  included  a  0.5  percent  CPD.
 No  sharing  obligations  were  imposed  on  LECs  that  chose  the  5.3  percent  option.
 23  1997  Price  Cap  Review  Order,  12  FCC  Rcd  at  16645.
 24  Dale  W.  Jorgenson  &  Zvi  Griliches,  The  Explanation  of  Productivity  Change,  34  Rev.  Econ.  Stud.  249
 (1967).
4
 Federal  Communications  Commission  FCC  99-  345
 5
 firm  (or  industry,  or  nation)  to  an  index  of  its  inputs.  Productivity  growth  is  measured  by  changes  in  this  ratio  over  time.  Beyond  showing  changes  in  the  amount  of  input  required  per  unit  of  output,  TFP  analysis
 generally  does  not  shed  light  on  the  mechanisms  by  which  productivity  growth  occurs.
 12.  In  TFP  models,  output  can  be  measured  either  in  terms  of  physical  units  of  the  service  produced,  such  as  minutes  or  calls,  or  by  dividing  revenues  by  an  index  of  output  prices.  Output  indices
 are  created  to  measure  changes  in  the  level  of  outputs  over  time.  Indices  for  particular  categories  of  output  are  weighted  to  create  a  single  output  index.  25
 13.  Inputs  are  usually  classified  into  three  categories:  labor,  materials,  and  capital  services.  Again,  indices  reflecting  changes  in  the  quantities  of  labor,  materials,  and  capital  services  are  weighted
 and  aggregated  into  a  single  input  index.  The  growth  rate  of  the  aggregate  input  index  depends  on  the  growth  rates  of  the  individual  input  indices  and  their  relative  weights.  Capital  services  are  assumed  to  be
 a  fixed  proportion  of  the  capital  stock  (i.  e.,  plant  and  equipment),  so  that  changes  in  capital  services  can  be  measured  through  measurement  of  changes  in  the  capital  stock.  26
 14.  In  a  regulatory  setting,  if  the  TFP  calculation  sets  the  X-  factor  too  low,  and,  consequently,  sets  prices  too  high,  end  users  will  purchase  less  of  the  services  produced,  and  the  quantity  of  output  will
 be  lower  than  if  prices  were  set  at  a  competitive  level.  The  productivity  of  which  the  plant  is  capable  will  not  be  revealed.  Since  the  marginal  cost  of  additional  output  is  believed  to  be  very  low  in
 telecommunications,  the  effect  on  measured  productivity  may  be  large.  27
 15.  The  1997  staff  TFP  study  calculated  the  historical  difference  in  productivity  growth  between  LECs  and  the  economy  nationwide  for  the  period  1986  through  1995.  Specifically,  it  calculated  the
 difference  between  LEC  TFP  change  and  economy-  wide  TFP  change.  The  study  then  calculated  an  input  price  differential  reflecting  the  difference  in  the  rate  of  the  change  of  LEC  input  prices  as  compared  with
 the  economy  as  a  whole.  These  two  factors  were  then  added  together  for  each  year.  Several  averages  were  created  using  these  numbers,  with  the  first  average  being  for  the  entire  period,  the  next  average
 dropping  the  oldest  year  (1986),  and  each  subsequent  average  dropping  another  year,  with  the  final  average  including  only  the  years  1991  to  1995.  These  averages  created  a  "zone  of  reasonableness"  of  5.2
 percent  to  6.1  percent.  Placing  some  reliance  on  slightly  higher  X-  factor  estimates  calculated  by  AT&  T,  the  Commission  increased  the  upper  bound  of  the  zone  of  reasonableness  to  6.3  percent.  The
 Commission  prescribed  an  X-  factor  near  the  upper  end  of  the  zone  of  reasonableness,  at  6.0  percent.  28
 16.  In  addition  to  the  6.0  percent  historical  portion  of  the  X-  factor,  the  Commission  retained  a  0.5  percent  CPD  "to  ensure  that  price  cap  LECs  flow-  through  a  reasonable  portion  of  the  benefits  of
 25  1997  Price  Cap  Review  Order,  12  FCC  Rcd  at  16657.
 26  1997  Price  Cap  Review  Order,  12  FCC  Rcd  at  16657-  58.  Capital  stock  in  the  base  year  of  a  TFP  study
 period  is  measured  by  the  book  value  of  plant.  For  the  second  year,  the  capital  stock  is  derived  by  reducing  the  first  period's  capital  stock  for  depreciation,  and  increasing  it  by  the  second  period's  plant  additions,  deflated  by  the
 change  in  capital  stock  prices.
 27  Bridger  M.  Mitchell  &  Ingo  Vogelsang,  Telecommunications  Pricing:  Theory  and  Practice  14  (1991).
 28  1997  Price  Cap  Review  Order,  12  FCC  Rcd  at  16696-  97.
5
 Federal  Communications  Commission  FCC  99-  345
 6
 productivity  growth  to  ratepayers."  29  The  Commission  stated  that  inclusion  of  a  CPD  was  especially  critical  in  achieving  this  goal  because  the  sharing  requirements  were  being  eliminated  from  the  price  cap
 plan.
 B.  Court  Decision
 17.  Several  entities  filed  petitions  for  review  of  the  1997  Price  Cap  Review  Order.  In  its  decision,  the  U.  S.  Court  of  Appeals  for  the  D.  C.  Circuit  generally  denied  the  petitioners'  challenges  to  the
 Commission's  decision,  but  reversed  and  remanded  for  further  explanation  of  several  aspects  of  the  analysis  supporting  the  Commission's  prescription  of  a  6.5  percent  X-  factor.  30
 18.  The  court  questioned  the  Commission's  stated  rationales  for  selecting  6.0  percent,  from  the  high  end  of  the  5.2-  6.3  percent  zone  of  reasonableness,  as  the  historical  component  of  the  X-  factor.
 Specifically,  the  court  found  that  the  Commission  had  not  supported  its  conclusion  that  the  two  lowest  TFP  year  averages,  from  1986-  1995  and  1991-  1995,  should  be  accorded  less  weight  in  the  selection  of  the
 X-  factor.  The  court  also  questioned  the  Commission's  reliance  on  an  upward  trend  in  the  X-  factor  from  1993,  noting  that  the  trend  could  be  part  of  a  larger  cyclical  pattern,  in  which  case  a  downward  turn  in  the
 X-  factor  could  be  expected.  In  addition,  the  court  noted  that  there  was  no  discernible  trend  in  either  of  the  two  X-  factor  components,  i.  e.,  the  differences  between  LEC  and  U.  S.  changes  in  TFP,  and  the
 differences  between  LEC  and  U.  S.  changes  in  input  prices.  Finally,  the  court  rejected  the  Commission's  reliance  on  AT&  T's  higher  X-  factor  results,  noting  that  the  Commission  had  incorporated  the  portions  of
 AT&  T's  study  deemed  reasonable  in  its  staff  study,  and  therefore  should  not  have  given  any  independent  weight  to  the  results  of  AT&  T's  study,  or  adjusted  the  range  of  reasonableness  upward  from  6.  1  percent.  31
 19.  The  court  also  sought  an  explanation  of  the  inclusion  of  a  0.5  percent  CPD  in  the  X-  factor.  Although  the  petitioners  did  not  dispute  "that  it  is  defensible  to  include  a  CPD  corresponding  to  whatever
 productivity  increase  may  be  expected  from  the  elimination  of  sharing",  the  court  found  that  retention  of  the  prior  CPD  amount  of  0.5  percent  required  a  comparison  of  the  productivity  effects  of  sharing
 elimination  with  the  initial  rationale  for  adopting  a  0.5  percent  CPD.  32
 III.  REPRESCRIPTION  OPTIONS
 20.  We  seek  comment  on  three  alternative  bases  for  prescribing  the  historical  component  of  the  X-  factor.  First,  we  could  prescribe  an  X-  factor  based  on  the  reasonable  range  determined  by  the  1997
 staff  TFP  study.  In  relying  on  this  basis  for  represcription,  we  would  address  only  those  issues  remanded  by  the  court.  We  discuss  this  approach  in  Section  III.  A.
 21.  Second,  we  could  rely  on  a  new  staff  study  revising  the  1997  staff  TFP  study  ("  1999  staff  TFP  study").  The  1999  staff  TFP  study  substitutes  an  independent  measure  of  capital  price  changes  for
 the  endogenously-  determined  capital  price  change  used  in  the  1997  staff  TFP  study  and  recalculates  the
 29  1997  Price  Cap  Review  Order,  12  FCC  Rcd  at  16690.
 30  USTA  v.  FCC,  188  F.  3d  at  530.
 31  USTA  v.  FCC,  188  F.  3d  at  525-  26.
 32  USTA  v.  FCC,  188  F.  3d  at  527.
6
 Federal  Communications  Commission  FCC  99-  345
 7
 change  in  the  compensation  of  the  capital  input.  The  revised  study  also  makes  adjustments  to  the  1997  staff  TFP  study  to  update  information  and  to  adjust  for  possible  biases.  We  discuss  this  approach  in  more
 detail  in  Section  III.  B.  The  1999  staff  TFP  study  appears  as  Appendix  B.
 22.  Third,  we  could  take  advantage  of  our  accumulated  experience  with  price  cap  regulation  and  directly  determine,  from  aggregate  interstate  expenses  and  revenues,  the  X-  factor  that,  if  it  had  been
 prescribed  from  the  inception  of  price  caps,  would  leave  capital  compensation  at  the  competitive  level  at  the  end  of  the  study  period.  We  discuss  this  methodology  in  detail  in  Section  III.  C.  A  staff  study  that
 applies  this  methodology  appears  as  Appendix  C  ("  staff  Imputed  X  study").
 23.  We  also  seek  comment  on  other  alternatives  that  would  serve  as  a  basis  for  prescribing  the  historical  component  of  the  X-  factor  for  the  remand  period.
 A.  Option  1:  The  1997  Staff  TFP  Study
 24.  We  seek  comment  on  whether  we  should  use  only  the  results  from  the  1997  staff  TFP  study  in  setting  the  historical  component  of  the  X-  factor  for  the  remand  period.  We  seek  comment  on  whether,
 in  addressing  the  court's  remand,  we  are  precluded  from  revising  the  X-  factor  using  any  other  methodology,  or  from  supplementing  the  data  in  the  1997  staff  TFP  study.
 25.  The  court  did  not  find  fault  with  the  1997  staff  TFP  study,  and  did  not  ask  us  to  revisit  it.  Instead,  the  court  limited  its  critique  of  TFP  to  our  selection  of  a  value  at  the  upper  end  of  the
 reasonableness  range,  and  with  the  upward  adjustment  to  the  reasonable  range.
 26.  In  their  responses  to  a  1998  request  to  refresh  the  record  in  our  Access  Charge  Reform  proceeding,  33  both  USTA  and  AT&  T  used  the  methodology  in  the  1997  staff  TFP  study  to  extend  the
 calculation  of  the  X-  factor  through  1997.  34  USTA  has  also  calculated  an  X-  factor  for  1998.  35  We  seek  comment  on  the  legal  and  logical  arguments  supporting  consideration  of  data  that  have  become  available
 after  the  close  of  the  record  for  the  remanded  prescription.  We  note  that  USTA  and  AT&  T  did  not  agree  with  each  other  on  the  value  of  the  historical  component  for  1996  and  1997.  We  seek  comment  on
 USTA's  and  AT&  T's  updates  of  the  1997  staff  TFP  study,  and  on  their  recommendations  for  prescribing  an  X-  factor.
 27.  If  we  set  the  X-  factor  by  using  the  1997  staff  TFP  study,  the  court's  remand  requires  that  we  justify  our  selection  from  within  the  reasonable  range.  Within  the  reasonable  range,  should  we  use  some
 measure  of  central  tendency,  e.  g.,  the  mean  or  median,  as  the  best  estimator  of  productivity?  Could  and  should  we  consider  prescribing  above  the  mean?  If  the  reasonable  range  includes  a  statistically
 meaningful  trend,  should  this  inform  our  choice?  What  other  justifications  could  be  made  for  selecting
 33  Commission  Asks  Parties  to  Update  and  Refresh  Record  for  Access  Charge  Reform  and  Seeks  Comment
 on  Proposals  for  Access  Charge  Reform  Pricing  Flexibility,  Public  Notice,  CC  Docket  Nos.  96-  262  et  al.,  13  FCC  Rcd  21522  (1998).
 34  See,  e.  g.,  Reply  Comments  of  AT&  T,  CC  Docket  94-  1,  Attachment  A  at  1  (Nov.  9,  1998);  Comments  of
 USTA,  CC  Docket  94-  1,  Attachment  D  at  3  (Oct.  26,  1998).
 35  See  Letter  from  Linda  L.  Kent,  Associate  General  Counsel,  USTA,  to  Magalie  Roman  Salas,  Secretary,
 FCC  (Sept.  10,  1999).
7
 Federal  Communications  Commission  FCC  99-  345
 8
 above  or  below  some  measure  of  central  tendency?  Should  these  justifications  affect  our  selection  from  the  reasonable  range,  or  are  they  more  relevant  to  the  selection  of  a  CPD?
 B.  Option  2:  The  1999  Staff  TFP  Study
 1.  Methodology
 28.  In  comments  filed  with  the  Commission  late  last  year,  several  parties  identified  what  they  believe  is  a  problem  in  the  way  in  which  the  1997  staff  TFP  study  employed  the  TFP  methodology
 commonly  used  in  economic  analysis  to  set  an  X-  factor.  36  The  1999  staff  TFP  study  takes  this  potential  problem  as  a  point  of  departure  and  attempts  to  correct  it.  We  seek  comment  on  the  1999  staff  TFP  study,
 and  on  its  premise  that  the  1997  staff  TFP  study  methodology  may  fail  to  calculate  an  X-  factor  that  is  consistent  with  the  objectives  of  our  price  cap  plan.
 29.  The  1997  staff  TFP  study  subtracts  the  cost  of  the  labor  and  material  inputs  from  revenues,  and  the  residual  revenue  is  assumed  to  be  the  cost  of  the  capital  input.  The  1999  staff  TFP  study  attempts
 to  capture  the  gains  in  productivity  that  would  have  been  revealed  in  a  competitive  marketplace  by  varying  total  capital  compensation  according  to  a  measure  of  the  competitive  capital  compensation  rate.
 30.  We  seek  comment  on  the  following  method  for  adjusting  the  capital  compensation  in  the  1997  staff  TFP  study.  37  The  first  step  is  to  identify  a  competitive  price  index  series  to  use  as  a  surrogate
 for  the  annual  change  for  the  cost  of  capital  in  a  competitive  market.  The  second  step  is  to  assume  LEC  capital  compensation  in  1991,  the  first  full  year  of  LEC  price  cap,  was  at  a  competitive  level.  38  The  third
 step  is  to  combine  the  competitive  price  index  and  the  1991  LEC  capital  compensation  rate  to  create  a  competitive  LEC  capital  compensation  rate  for  the  historical  period.  The  fourth  step  is  to  increase  or
 decrease  LEC  capital  compensation  based  on  this  competitive  LEC  capital  compensation  rate.  The  fifth  step  is  to  adjust  LEC  revenues,  making  appropriate  allowance  for  taxes,  for  the  change  in  capital
 compensation.  The  final  step  is  to  recalculate  LEC  historical  TFP  using  these  revised  capital  compensation  and  revenue  data.
 31.  In  addition  to  updating  the  data  for  the  period  1996-  1998,  the  1999  staff  TFP  study  makes  three  other  modifications  to  the  1997  staff  TFP  study.  39  First,  the  1999  staff  TFP  study  uses  the  recently
 revised  Bureau  of  Labor  Statistics  ("  BLS")  series  on  multifactor  productivity  in  place  of  the  antecedent
 36  See  Reply  Comments  of  Ad  Hoc,  CC  Docket  No.  94-  1  at  18  (Nov.  9,  1998)  (arguing  that  the
 Commissions  model,  measuring  the  input  cost  of  capital  as  a  firms  overall  return  on  investment,  does  not  accurately  calculate  the  capital  costs  in  a  market  that  is  not  competitive);  Reply  Comments  of  AT&  T,  CC  Docket
 No.  94-  1  at  19  (Nov.  9,  1998)  (arguing  that  the  Commissions  miscalculated  increase  in  incumbent  LEC  input  prices  is  due  mainly  to  the  huge  surge  in  incumbent  LEC  operating  earnings  in  1996  and  1997);  Reply  Comments  of  MCI,
 CC  Docket  No.  94-  1  at  27-  28  (Nov.  9,  1998)  (arguing  that,  under  the  Commissions  X-  factor  calculation,  higher  earnings  on  the  part  of  LECs  would  actually  suggest  lower  productivity).
 37  Details  of  the  adjustment  can  be  found  in  Appendix  B.
 38  Because  price  caps  were  implemented  in  1991,  the  1999  staff  TFP  study  assumes  that  LECs  earned  a
 normal  return  in  that  year.
 39  A  detailed  discussion  of  these  issues  is  set  forth  in  Appendix  B.
8
 Federal  Communications  Commission  FCC  99-  345
 9
 series.  Second,  the  1999  staff  TFP  study  uses  the  number  of  dial  equipment  minutes,  rather  than  the  number  of  calls,  in  calculating  the  local  service  output  index.  Third,  the  1999  staff  TFP  study  recalculates
 the  labor  input  to  adjust  for  the  fact  that  all  the  costs,  but  only  a  fraction  of  the  benefits,  of  the  1992-  95  employee  buyouts  have  been  recognized  on  the  accounting  books.  We  seek  comment  on  these
 modifications  to  the  1997  staff  TFP  study.
 32.  Several  additional  aspects  of  the  1997  staff  TFP  study  may  warrant  highlighting  and  comment.  40  The  1999  staff  TFP  study  does  not  make  these  adjustments  because  they  either  are  not  easily
 quantified,  or  do  not  make  a  significant  impact  on  the  level  of  the  X-  factor.  We  seek  comment  on  the  decision  of  the  1999  staff  TFP  study  to  not  make  any  of  these  adjustments.  We  also  seek  comment  on
 whether  there  are  any  additional  issues,  not  noted  here  or  in  Appendix  A,  that  necessitate  adjusting  the  X-factor,  how  any  such  adjustments  would  affect  the  X-  factor,  and  how  they  should  be  made.
 2.  Selecting  the  Appropriate  X-  Factor
 33.  The  court's  remand  requires  that  we  justify  our  selection  from  within  a  reasonable  range.  We  seek  comment  on  how  we  should  determine  the  reasonable  range  and  how  we  should  select  from  within
 this  range.  In  our  determination  of  the  reasonable  range  in  the  1997  Price  Cap  Review  Order,  we  gave  recent  years  more  weight  than  more  distant  years.  41  Should  we  continue  to  discount  more  distant  years?
 Should  the  period  under  price  cap  regulation  be  given  more  weight  than  the  period  under  rate-  of-  return  regulation?  Given  that  price  cap  regulation  may  have  been  anticipated  by  price  cap  LECs  for  some  years
 before  its  introduction,  what  years  should  be  included  in  the  price  cap  period?
 34.  We  also  seek  comment  on  whether  additional  years  of  data  should  be  considered  in  the  remand,  or  whether  the  X-  factor  we  select  should  rely  on  the  same  years  of  data  as  used  in  the  1997  Price
 Cap  Review  Order.  We  seek  comment  on  the  legal  and  logical  arguments  supporting  consideration  of  data  that  have  become  available  after  the  close  of  the  record  for  the  remanded  prescription.  Would  it  be
 more  responsive  to  the  court's  remand  to  prescribe  an  X-  factor  based  on  data  available  in  1997  or  to  consider  the  additional  data  that  has  become  available  in  the  interim  in  setting  the  X-  factor  on  a  going-forward
 basis?
 C.  Option  3:  The  Staff  Imputed  X  Study
 1.  Methodology
 35.  As  an  alternative  to  either  of  the  TFP  methodologies,  the  Bureau  staff  also  has  performed  a  study,  the  staff  Imputed  X  study,  designed  to  calculate  the  X  factor  that  yields  the  aggregate  revenues  that
 would  have  been  generated  in  a  competitive  market.  42  While  price  caps  provide  incentives  for  cost  reduction  similar  to  those  of  competition,  they  do  not  guarantee  that  revenues  will  follow  a  similar  path.
 In  a  competitive  market,  revenues  on  average  will  be  equal  to  costs,  including  compensation  of  capital  at  a  competitive  market  level.  This  method  is  intended  to  replicate  the  effects  of  a  competitive  market  in
 apportioning  the  gains  from  successful  operation  between  carriers  and  consumers.  The  approach  used
 40  See  Appendix  A  at  Section  III.
 41  1997  Price  Cap  Review  Order,  12  FCC  Rcd  at  16696.
 42  The  results  are  presented,  and  the  calculations  are  described  fully,  in  Appendix  C.
9
 Federal  Communications  Commission  FCC  99-  345
 10
 here  differs  from  the  TFP  approach,  inter  alia,  in  that  it  measures  productivity  growth  by  looking  at  aggregate  expense  and  revenue  data  rather  than  by  weighting  and  aggregating  categories  of  physical
 inputs  and  outputs.  In  contrast  to  both  of  the  TFP  approaches,  this  method  appears  to  have  modest  data  requirements  and  to  be  computationally  simple  and  easily  understandable.  Nevertheless,  this  method
 should  have  the  same  incentive  effects  as  the  TFP  approach  or  any  other  method  of  calculating  an  X-factor.
 36.  The  staff  Imputed  X  study  calculates  the  change  in  1998  revenue  and  operating  income  for  each  price  cap  LEC  that  would  result  from  imposing  a  hypothetical  X-  factor  from  the  inception  of  price
 caps  in  1991  through  1998.  The  results  for  all  price  cap  LECs  are  aggregated,  and  the  X  factor  required  to  produce  revenues  equal  to  costs,  including  a  competitive  level  of  capital  compensation  in  the  aggregate
 for  all  LECs,  is  calculated.  The  calculation  was  also  performed  for  1991  through  1995  for  comparison  with  the  original  TFP  study.  The  calculation  takes  account  of  the  increase  in  the  demand  for  service  that
 would  have  resulted  from  the  lower  price.  Changes  in  the  competitive  cost  of  capital  were  accounted  for  by  adjusting  the  capital  compensation  found  reasonable  by  the  Commission  at  the  inception  of  price  caps
 by  an  index  of  bond  rates  over  the  period.  The  index  is  the  same  one  used  for  the  1999  staff  TFP  study  to  measure  the  price  of  capital.  43
 37.  The  data  used  for  these  estimates  differ  from  those  used  for  the  TFP  calculations  in  that  they  are  purely  interstate  in  nature.  The  TFP  calculations  used  total  company  data  because  of  the  difficulty  of
 separating  interstate  and  intrastate  costs  for  the  TFP  calculations,  despite  interstate  data  being  conceptually  more  appropriate  for  representing  the  services  regulated  by  the  Commission  under  price
 caps.  44  The  data  for  the  staff  Imputed  X  study  also  include  all  price  cap  carriers,  whereas  the  TFP  studies  use  data  for  the  regional  Bell  operating  companies  ("  RBOCs")  only.  The  calculations  assume  that  a
 decrease  in  price  would  result  in  an  increase  in  the  quantity  of  service  purchased,  while  the  TFP  calculations  necessarily  reflect  only  experience  under  the  prices  that  were  actually  in  effect.  Finally,  the
 staff  Imputed  X  study  does  not  make  an  adjustment  in  expense  data  comparable  to  the  adjustment  made  in  the  1999  staff  TFP  study  to  compensate  for  the  accounting  treatment  of  employee  buyouts.  To  provide  a
 check  on  the  revised  TFP  calculations,  the  X-  factor  calculations  using  the  staff  Imputed  X  study  were  repeated  using  data  only  for  the  RBOCs  and  assuming  no  demand  growth  in  response  to  lower  prices.
 These  calculations  were  performed  for  both  1995  and  1998.
 2.  Previous  Study
 38.  We  note  that  the  approach  described  here  is  similar  to  the  Direct  Model  proposed  by  AT&  T,  which  the  Commission  has  referred  to  as  the  Historical  Revenue  Approach.  45  The  staff  Imputed  X  study
 43  Moody's  Baa  corporate  bond  rate  was  used.  We  noted  above  that,  in  a  competitive  capital  market,
 indexes  of  bond  rates  will  agree  closely.  Further,  in  an  efficient  market,  there  are  no  persistent  arbitrage  opportunities  between  different  financial  instruments,  so  that  we  have  no  reason  to  expect  that  the  trend  of  bond
 rates  would  differ  over  time  from  that  of  the  return  on  an  efficient  diversified  portfolio.  Thus,  applying  any  of  several  published  indices  to  the  allowed  rate  at  the  beginning  of  the  period  will  yield  approximately  the  same
 estimate  of  the  end-  period  rate.
 44  Price  Cap  Performance  Review  for  Local  Exchange  Carriers,  Fourth  Further  Notice  of  Proposed
 Rulemaking,  CC  Docket  No.  94-  1,  10  FCC  Rcd  13659,  13669  (1995)  ("  Price  Cap  Fourth  Further  Notice").
 45  Price  Cap  Fourth  Further  Notice,  10  FCC  Rcd  13671-  72;  1997  Price  Cap  Review  Order,  12  FCC  Rcd
 16653-  54,  16725.
10
 Federal  Communications  Commission  FCC  99-  345
 11
 differs  from  the  approach  proposed  by  AT&  T  primarily  in  that  the  staff  calculation  includes  an  adjustment  to  take  account  of  likely  demand  stimulation  resulting  from  a  lower  price  cap,  and  the
 calculation  takes  account  of  changes  over  time  in  competitive  return  to  capital.  Data  sources  and  calculations  also  differ  somewhat.  In  the  1995  Price  Cap  Review  Order,  the  Commission  noted  that  the
 Historical  Revenue  Approach  has  the  advantage  that  it  reflects  performance  in  providing  the  interstate  services  that  are  subject  to  price  caps,  and  includes  input  cost  changes.  46  In  comments  to  the  Price  Cap
 Fourth  Further  Notice,  GSA  supported  the  Historical  Revenue  Approach  and  noted  that  it  incorporates  both  TFP  growth  and  the  input  price  differential.  47
 39.  Most  criticisms  of  AT&  T's  Historical  Revenue  Approach  dealt  with  the  data  and  methodology  used  by  AT&  T  in  its  calculations.  48  Commenters  responding  to  AT&  T's  proposal  pointed
 out  that  data  reported  under  Commission  accounting,  separations,  and  other  rules  may  not  accurately  track  economic  costs.  49  NYNEX  in  its  comments  to  the  Price  Cap  Fourth  Further  Notice  criticized  use  of  the
 Historical  Revenue  Approach  on  the  grounds  that  accounting-  based  rules  are  a  poor  measure  of  a  firm's  economic  performance.  50  We  note  that  the  Commission  declined  to  adopt  the  Historical  Revenue
 Approach  in  the  1997  Price  Cap  Review  Order  due  to  administrative  concerns  and  incentive  effects.  51
 3.  Request  for  Comment
 40.  We  seek  comment  on  the  validity  of  the  staff  Imputed  X  study  for  estimating  the  appropriate  level  of  the  X-  factor.  Does  the  X-  factor  estimated  using  these  data  and  assumptions  accurately  represent
 the  productivity  growth  achievable  by  the  price  cap  LECs  over  the  period  examined?  We  request  comment  on  the  theoretical  appropriateness  of  this  methodology.  We  also  seek  comment  on  the
 following  questions:  Is  an  interstate-  only  calculation  conceptually  proper,  and  do  the  data  allow  an  accurate  measure  of  interstate  revenues,  expenses,  and  investment?  Calculations  reported  in  Appendix  C
 show  that  X-  factors  calculated  on  an  annual  basis  appear  to  increase  over  time.  Are  there  explanations  for  the  trend  we  see  other  than  increasing  efficiency?  Does  this  apparent  trend  suggest  that  an  additional
 adjustment,  such  as  the  CPD,  is  necessary  in  addition  to  revising  the  calculation  of  the  X-  factor?  Alternatively,  is  the  CPD  no  longer  necessary  because  the  approach  described  here  sufficiently  passes  the
 benefits  of  increased  efficiency  to  ratepayers?  What  is  the  appropriate  method  for  determining  the  competitive  cost  of  capital?  Is  applying  an  index  of  bond  rates  to  the  rate  of  return  used  by  the
 Commission  to  initialize  rates  at  the  inception  of  price  caps  a  reasonable  approach?  Would  taking  account  of  the  mix  of  debt  and  equity  held  by  the  LECs  yield  a  more  accurate  estimate  of  the  trend  in  the
 cost  of  capital?
 46  1995  Price  Cap  Review  Order,  10  FCC  Rcd  at  9034.
 47  1997  Price  Cap  Review  Order,  12  FCC  Rcd  at  16725.
 48  See  1995  Price  Cap  Review  Order,  10  FCC  Rcd  9019-  20,  9021.
 49  See  1995  Price  Cap  Review  Order,  10  FCC  Rcd  at  9034.
 50  See  1997  Price  Cap  Review  Order,  12  FCC  Rcd  at  16725.
 51  1997  Price  Cap  Review  Order,  12  FCC  Rcd  at  16653-  54.
11
 Federal  Communications  Commission  FCC  99-  345
 12
 41.  We  request  comment  on  the  data  and  calculations  used  in  the  staff  Imputed  X  study.  Are  more  appropriate  data  sources  available,  and  can  adjustments  be  made  that  would  improve  the  accuracy  of
 the  calculations  reported  here?  AT&  T  in  its  Historical  Revenue  Approach  in  1994  used  Price  Cap  Indices  ("  PCIs")  from  the  Commission's  Tariff  Review  Plan  data  to  measure  actual  changes  in  allowed  rates.  52
 This  approach  includes  all  changes  that  occurred  in  the  price  caps,  including  exogenous  changes  not  related  to  the  operation  of  the  X  factor.  Is  such  an  approach  conceptually  appropriate?  Would  use  of
 PCIs  rather  than  the  X  factor  in  effect  more  accurately  reflect  price  performance  for  purposes  of  these  calculations?
 42.  We  also  seek  comment  on  whether,  in  responding  to  the  remand,  it  is  appropriate  to  use  data  for  the  period  that  was  available  to  us  at  the  time  of  the  1997  Price  Cap  Review  Order,  or  whether  we
 should  make  use  of  the  best  information  available  to  us  now,  including  data  for  subsequent  years  that  have  become  available  in  the  meantime.  We  seek  comment  on  the  legal  and  logical  arguments  supporting
 consideration  of  data  that  have  become  available  after  the  close  of  the  record  for  the  remanded  prescription.  Would  it  be  more  responsive  to  the  court's  remand  to  prescribe  an  X-  factor  based  on  data
 contemporaneous  with  the  prescription  and  to  consider  the  additional  data  in  setting  the  X-  factor  on  a  going-  forward  basis?  In  addition,  the  court's  remand  requires  that  we  justify  our  selection  from  within  a
 reasonable  range.  How  should  we  determine  a  reasonable  range  for  setting  the  X-  factor  using  the  staff  Imputed  X  study,  and  how  we  should  select  from  within  that  range?
 IV.  CONSUMER  PRODUCTIVITY  DIVIDEND
 43.  In  the  LEC  Price  Cap  Order,  the  Commission  included  a  CPD  of  0.5  percent  in  the  X-  factor  offset  to  ensure  that  access  customers  received  the  first  benefits  of  price  caps  in  the  form  of  reduced
 rates.  53  This  CPD  was  also  included  in  the  X-  factor  in  subsequent  price  cap  review  orders,  including  the  1997  Price  Cap  Review  Order,  in  which  it  was  intended  to  offset  the  elimination  of  sharing
 requirements.  54  These  requirements  had  compelled  price  cap  LECs  to  share  a  portion  of  their  earnings  above  set  percentages  with  access  customers.  55  The  sharing  requirements  were  intended  to  protect
 consumers  against  the  possibility  of  an  error  in  the  establishment  of  the  X-  factor.  56  Pursuant  to  the  court's  remand,  the  Commission  seeks  comment  on  whether  to  retain  the  CPD.
 44.  In  remanding  this  issue  to  the  Commission,  the  court  specifically  questioned  the  quantification  of  the  CPD.  When  the  Commission  made  its  decision  to  include  a  CPD  in  the  1997  X-factor,
 the  record  included  a  study  by  Strategic  Policy  Research  (  SPR)  that  addressed  the  effects  of  eliminating  the  sharing  requirements.  57  The  SPR  study  found  that  the  LEC  price  cap  plan  with  sharing
 52  AT&  T  Comments  in  CC  Docket  No.  94-  1,  at  App.  B  (May  9,  1994).
 53  LEC  Price  Cap  Order,  5  FCC  Rcd  at  6799.
 54  1995  Price  Cap  Review  Order,  10  FCC  Rcd  at  9053-  54;  1997  Price  Cap  Review  Order,  12  FCC  Rcd  at
 16690-  91.
 55  1997  Price  Cap  Review  Order,  12  FCC  Rcd  at  16649.
 56  Price  Cap  Fourth  Further  Notice,  10  FCC  Rcd  at  13660.
 57  See  Comments  of  Southwestern  Bell  Telephone  Company,  CC  Docket  No.  94-  1,  App.  SPR  (May  9,
 1994)  (  SPR  study).
12
 Federal  Communications  Commission  FCC  99-  345
 13
 requirements  produced  less  than  35  percent  of  the  efficiency  incentives  of  unregulated  competition.  Those  incentives  decreased  to  18  percent  for  price  cap  LECs  whose  earnings  were  in  the  50-  50  sharing
 category  for  each  year  of  the  four-  year  review  cycle.  58  The  results  of  the  SPR  study  were  challenged  by  the  Ad  Hoc  Telecommunications  Users  Committee  (  Ad  Hoc),  but  Ad  Hoc's  own  results  indicated  that
 sharing  substantially  reduced  efficiency  incentives.  59  Ad  Hoc's  more  conservative  calculations  indicated  that  elimination  of  sharing  would  increase  efficiency  incentives  by  at  least  17  percent  for  all  LECs,  and  by
 41  percent  for  LECs  in  the  50-  50  sharing  category.  60  We  seek  comment  on  the  CPD  amount  justified  on  the  basis  of  these  studies  to  ensure  that  the  benefits  of  sharing  elimination  would  be  apportioned  between
 LECs  and  ratepayers.  We  also  seek  comment  on  additional  methods  for  quantifying  a  CPD  designed  to  ensure  that  consumers  get  a  reasonable  portion  of  the  benefits  from  the  elimination  of  sharing.
 45.  We  also  seek  comment  on  whether  a  CPD  should  be  included  to  reduce  rates  and  correct  for  prior  years  when  the  X-  factor  may  have  been  set  too  low.  As  noted  above  in  Section  III,  the  calculations
 used  to  set  prior  year  X-  factors  may  have  underestimated  LEC  productivity.  This  underestimation  may  have  caused  rates  to  be  set  at  too  high  a  level.  A  mistake  in  the  X-  factor  may  not  be  self-  correcting,  but
 instead  may  cause  increasingly  erroneous  prices  over  time.  61  To  obtain  efficient  prices  in  the  future,  it  may  be  necessary  both  to  adjust  the  value  of  the  X-  factor  and  to  reset  prices.  Therefore,  we  seek  comment
 on  whether  we  should  include  in  the  X-  factor  a  CPD  designed  to  reduce  rates,  either  by  a  one-  time  adjustment,  or  over  a  multi-  year  period,  if  we  conclude  that  the  X-  factor  historically  has  been  set  too  low.
 If  the  reduction  occurs  over  a  multi-  year  period,  should  we  account  for  the  time  value  of  money,  and,  if  so,  how  should  we  calculate  the  reduction?  The  following  table  sets  forth  what  CPD  might  be  appropriate
 to  correct  for  productivity  underestimations  in  prior  year  X-  factors  depending  on  the  X-  factor  that  we  prescribe.
 58  1995  Price  Cap  Review  Order,  10  FCC  Rcd  at  9045.  The  Commission  discussed  the  SPR  study  in  some
 detail  in  the  1995  Price  Cap  Review  Order.  10  FCC  Rcd  at  9039.  Although  the  Commission  did  not  determine  whether  the  SPR  study  accurately  quantified  the  effects  of  sharing  on  productivity  growth,  it  concluded  that  the
 study  showed  that  there  are  substantial  gains  in  incentives  that  [sharing]  suppresses.  1995  LEC  Price  Cap  Review  Order,  10  FCC  Rcd  at  9046.
 59  See  Reply  Comments  of  Ad  Hoc,  CC  Docket  No.  94-  1,  14-  18  (June  30,  1994).
 60  1995  Price  Cap  Review  Order,  10  FCC  Rcd  at  9046.
 61  Michael  A.  Crew  &  Paul  R.  Kleindorfer,  Incentive  Regulation  in  the  United  Kingdom  and  the  United
 States:  Some  Lessons,  9  J.  Reg.  Econ.  211  (1996).
13
 Federal  Communications  Commission  FCC  99-  345
 14
 RATE  REDUCTION  IN  1998  IMPLIED  BY  NEW  X-  FACTOR  PRESCRIPTION
 ______________________________________________________________________________
 Overstatement  Annual  Consumer  X-  Factor  of  Price  Indices  62  Benefits  Lost  63
 (%)  (%)  ($  billion)  ______________________________________________________________________________
 5.0  0.14  -  0.44  0.24  5.5  3.19  -  4.36  1.16
 6.0  7.10  -  8.14  2.06  6.5  10.70  -  11.  79  2.95
 7.0  14.26  -  15.  31  3.80  7.5  17.69  -  18.  71  4.64
 8.0  21.00  -  21.  98  5.45  8.5  24.20  -  25.  15  6.23
 ______________________________________________________________________________
 V.  PRESCRIBING  THE  X-  FACTOR  ON  A  GOING-  FORWARD  BASIS
 46.  We  seek  comment  on  whether  we  should  prescribe  an  X-  factor  that  would  apply  as  of  July  1,  2000  that  is  different  from  the  retrospective  X-  factor  applicable  to  the  period  affected  by  the  court's
 remand,  or  whether  the  X-  factor  that  we  prescribe  for  the  period  beginning  July  1,  1997  should  continue  in  place  until  the  next  price  cap  performance  review.  We  also  seek  comment  on  whether  to  include  a
 prospective  CPD  adjustment  in  future  X-  factors  to  correct  for  any  significant  divergences  between  historic  LEC  productivity  and  prior  X-  factors,  and  on  whether  any  such  adjustment  should  be  made  at
 once  or  be  phased  in  over  several  years.
 47.  In  this  Notice  we  seek  comment  on  prescribing  a  future  X-  factor  based  on  the  results  of  the  1999  staff  TFP  study.  64  In  the  alternative,  we  could  prescribe  an  X-  factor  based  on  the  results  of  the  staff
 62  The  change  in  price  required  to  achieve  the  price  level  that  would  have  resulted  from  a  constant
 hypothetical  X-  factor  differs  among  carriers  because  the  carriers  chose  different  actual  X-  factors  in  the  period  1991-  1994.  Note  that  in  some  cases  price  changes  of  this  magnitude  would  not  be  permitted  under  current  rules.
 63  Consumer  benefits  include  both  savings  from  lower  rates  on  units  that  were  bought  without  rate
 reduction  and  benefits  from  additional  quantities  that  would  have  been  bought  if  rates  had  been  reduced.  These  figures  assume  all  rate  reductions  are  passed  on  in  lower  interstate  rates  for  end  users.  Consumer  benefits  were
 calculated  separately  for  each  carrier  given  that  carriers  rate  reductions  and  summed  over  all  carriers.
 64  See  supra  Section  III.  B;  and  infra  Appendix  B.
14
 Federal  Communications  Commission  FCC  99-  345
 15
 Imputed  X  study.  65  Finally,  we  invite  parties  to  comment  on  other  alternatives  that  could  serve  as  a  basis  for  a  future  X-  factor.
 48.  We  also  seek  comment  on  how  the  prescription  of  the  X-  factor  would  affect  smaller  price  cap  LECs  differently  from  other  price  cap  LECs,  and  whether  there  should  be  a  separate  X-  factor  calculated
 for  smaller  price  cap  LECs.
 49.  In  addition,  we  seek  comment  on  how  the  Commission's  proposed  adjustments  to  the  price  cap  rate  structure  66  should  affect  the  annual  reductions  required  by  our  price  cap  rules.  We  proposed  in
 our  recent  Pricing  Flexibility  Order  to  add  a  q  factor  to  the  formulae  used  to  adjust  annually  the  price  cap  indices  (  PCIs)  for  the  baskets  that  contain  the  charges  for  local  switching  and  tandem  switching.  67
 The  q  factor  would  reduce  switching  charges  based  on  growth  in  demand.  68  As  proposed,  the  affected  baskets  would  be  reduced  annually  by  both  the  X-  factor  and  the  q  factor.  The  staff  studies  attached
 herein,  however,  may  capture  in  their  X-  factor  estimates  some  or  all  of  the  effect  intended  to  be  captured  by  the  q  factor.  We  seek  comment  on  whether  a  q  factor  is  necessary  if  an  X-  factor  is  adopted  that
 captures  its  effect,  and  on  how  to  remove  any  double  counting  that  might  result  from  the  application  of  both  factors.  For  example,  if  the  X-  factor  reduction  was  $10,  and  the  q  factor  reduction  was  $4,  then  we
 could  directly  apply  $4  to  the  baskets  containing  local  and  tandem  switching,  and  allocate  the  remaining  $6  amongst  all  the  baskets  according  to  our  price  cap  rules.
 50.  We  also  proposed  to  adjust  on  a  prospective  basis  for  the  past  absence  of  a  q  factor  in  the  formulae  that  annually  adjust  the  PCIs  of  the  baskets  containing  charges  for  local  and  tandem  switching.  69
 We  seek  comment  on  how  any  such  adjustment  should  affect  any  proposed  adjustment  to  the  PCIs  for  all  price  cap  baskets  to  offset  the  cumulative  effect  of  past  X-  factors  that  may  have  been  set  below  the  rate  of
 cost  reduction  actually  achieved  by  LECs.  Should  we  apply  the  logic  suggested  in  the  example  of  the  previous  paragraph?  If  so,  should  the  shift  of  switching  ports  to  common  line  increase  the  common  line
 basket's  share  of  any  adjustment  based  on  the  past  absence  of  a  q  factor?
 51.  In  addition  to  proposing  a  q  factor,  we  proposed  to  increase  the  g  factor  that  applies  to  certain  revenues  in  the  common  line  basket  from  g/  2  to  a  full  g.  We  seek  comment  on  whether  any
 prospective  adjustment  to  our  X-  factor  prescription  would  be  appropriate  to  account  for  this.  70
 52.  Finally,  we  proposed  to  replace  the  existing  per-  minute  rate  structure  for  local  switching  and  tandem  switching  with  capacity  charges.  71  We  seek  comment  on  whether  replacing  per-  minute  charges
 65  See  supra  Section  III.  C;  and  infra  Appendix  C.
 66  Access  Charge  Reform,  Fifth  Report  and  Order  and  Further  Notice  of  Proposed  Rulemaking,  CC  Docket
 Nos.  96-  262  et  al.,  FCC  99-  206,  paras.  207-  227  (rel.  Aug.  27,  1999)  (  Pricing  Flexibility  Order).
 67  Pricing  Flexibility  Order  at  paras.  217-  220,  225.
 68  The  q  factor  would  operate  similarly  to  the  g  factor  present  in  the  common  line  PCI  formula.  See
 Pricing  Flexibility  Order  at  para.  218.  The  g  factor  is  used  to  share  with  IXCs  the  benefits  of  demand  growth  that  LECs  receive  from  per-  minute  growth  per  access  line.  LEC  Price  Cap  Order,  5  FCC  Rcd  at  6794.
 69  Pricing  Flexibility  Order  at  paras.  222,  225.
 70  Pricing  Flexibility  Order  at  para.  227.
15
 Federal  Communications  Commission  FCC  99-  345
 16
 with  capacity  charges  affects  future  growth  in  LEC  productivity.  We  seek  comment  on  whether  any  prospective  adjustment  to  our  X-  factor  is  required  and  on  how  we  would  quantify  this  adjustment.
 VI.  PROCEDURAL  ISSUES
 A.  Ex  Parte  Presentations
 53.  This  proceeding  shall  be  treated  as  a  permit-  but-  disclose  proceeding  in  accordance  with  Section  1.1206(  b)  of  the  Commission's  rules,  47  C.  F.  R.    1.1206(  b).  Ex  parte  presentations  are
 permissible  if  disclosed  in  accordance  with  Commission  Rules,  except  during  the  Sunshine  Agenda  period  when  presentations,  ex  parte  or  otherwise,  are  generally  prohibited.  Persons  making  oral  ex  parte
 presentations  are  reminded  that  memoranda  summarizing  the  presentations  must  contain  summaries  of  the  substance  of  the  presentations  and  not  merely  a  listing  of  the  subjects  discussed.  More  than  a  one  or  two
 sentence  description  of  the  views  and  arguments  presented  generally  is  required.  See  47  C.  F.  R.    1.1206(  b)(  2).  Additional  rules  pertaining  to  oral  and  written  presentations  are  set  forth  in  Section
 1.1206(  b).
 B.  Initial  Regulatory  Flexibility  Act  Analysis
 54.  As  required  by  the  Regulatory  Flexibility  Act  (  RFA)  72  ,  the  Commission  has  prepared  this  Initial  Regulatory  Flexibility  Analysis  (  IRFA)  of  the  possible  significant  economic  impact  on  small
 entities  by  the  policies  and  rules  proposed  in  this  Notice.  Written  public  comments  are  requested  on  this  IRFA.  Comments  must  be  identified  as  responses  to  the  IRFA  and  must  be  filed  by  the  deadlines  for
 comments  on  the  Notice  provided  below  in  Section  VI.  C.  The  Office  of  Public  Affairs  will  send  a  copy  of  the  Notice,  including  this  IRFA,  to  the  Chief  Counsel  for  Advocacy  of  the  Small  Business
 Administration.  73  In  addition,  the  Notice  and  IRFA  (or  summaries  thereof)  will  be  published  in  the  Federal  Register.  74
 55.  Need  for  and  Objectives  of  the  Proposed  Rules.  As  stated  in  Section  II.  B  above,  the  court  has  remanded  to  the  Commission  the  selection  of  a  6.  5  percent  productivity  offset,  or  X-  factor,  in  the  LEC
 price  cap  formula.  In  this  Notice  we  seek  comment  on  how  we  should  represcribe  an  X-  factor.  In  Section  III  we  seek  comment  on  prescribing  one  or  more  X-  factors  to  address  retroactively  the  period
 affected  by  the  court  remand  (July  1,  1997  to  June  30,  2000),  and  in  Section  V  we  seek  comment  on  represcribing  one  or  more  X-  factors  from  July  1,  2000  forward.  Further,  we  seek  comment  on  resetting,
 on  a  forward-  looking  basis,  price  cap  LEC  prices  to  a  level  that  is  consistent  with  any  X-  factor  prescription  in  order  to  rebalance  the  sharing  of  benefits  of  price  caps  between  LECs  and  their  customers.
 71  Pricing  Flexibility  Order  at  paras.  213-  216,  223-  225.
 72  See  5  U.  S.  C.    603.  The  RFA,  5  U.  S.  C.    601  et  seq.,  has  been  amended  by  the  Contract  With  America
 Advancement  Act  of  1996,  Pub.  L.  No.  104-  121,  110  Stat.  847  (1996)  (  CWAAA).  Title  II  of  the  CWAAA  is  the  Small  Business  Regulatory  Enforcement  Fairness  Act  of  1996  (  SBREFA).
 73  See  5  U.  S.  C.    603(  a).
 74  See  id.
16
 Federal  Communications  Commission  FCC  99-  345
 17
 56.  Legal  Basis.  The  proposed  action  is  supported  by  Sections  1,  4(  i),  4(  j),  201-  205,  and  303(  r)  of  the  Communications  Act  of  1934,  as  amended,  47  U.  S.  C.    151,  154(  i),  (j),  201-  205,  and  303(  r).
 57.  Description  and  Estimate  of  the  Number  of  Small  Entities  to  Which  the  Proposed  Rules  Will  Apply.  The  RFA  directs  agencies  to  provide  a  description  of  and,  where  feasible,  an  estimate  of  the
 number  of  small  entities  that  may  be  affected  by  the  proposed  rules,  if  adopted.  75  The  RFA  generally  defines  the  term  small  entity  as  having  the  same  meaning  as  the  terms  small  business,  small
 organization,  and  small  governmental  jurisdiction.  76  In  addition,  the  term  small  business  has  the  same  meaning  as  the  term  small  business  concern  under  the  Small  Business  Act.  77  A  small  business
 concern  is  one  which:  (1)  is  independently  owned  and  operated;  (2)  is  not  dominant  in  its  field  of  operation;  and  (3)  satisfies  any  additional  criteria  established  by  the  Small  Business  Administration
 (  SBA).  78  The  SBA  has  defined  a  small  business  for  Standard  Industrial  Classification  (  SIC)  category  4813  (Telephone  Communications,  Except  Radiotelephone)  to  be  an  entity  that  has  no  more  than  1,500
 employees.  79
 58.  We  have  included  small  incumbent  LECs  in  this  RFA  analysis.  As  noted  above,  a  small  business  under  the  RFA  is  one  that,  inter  alia,  meets  the  pertinent  small  business  size  standard  (e.  g.,  a
 telephone  communications  business  having  1,500  or  fewer  employees),  and  is  not  dominant  in  its  field  of  operation.  80  The  SBA's  Office  of  Advocacy  contends  that,  for  RFA  purposes,  small  incumbent  LECs
 are  not  dominant  in  their  field  of  operation  because  any  such  dominance  is  not  national  in  scope.  81  We  have  therefore  included  small  incumbent  LECs  in  this  RFA  analysis,  although  we  emphasize  that  this
 RFA  action  has  no  effect  on  Commission  analyses  and  determinations  in  other,  non-  RFA  contexts.
 59.  The  proposals  in  the  Notice  apply  only  to  price  cap  LECs.  At  the  current  time,  there  are  13  price  cap  LECs.  Of  these  companies,  11  are  listed  in  the  Commission's  most  recent  Statistics  of
 75  5  U.  S.  C.    603(  b)(  3).
 76  5  U.  S.  C.    601(  6).
 77  Small  Business  Act,  15  U.  S.  C.    632.
 78  5  U.  S.  C.    601(  3)  (incorporating  by  reference  the  definition  of  small  business  concern  in  15  U.  S.  C.  
 632).  Pursuant  to  the  RFA,  the  statutory  definition  of  a  small  business  applies  unless  an  agency,  after  consultation  with  the  Office  of  Advocacy  of  the  Small  Business  Administration  and  after  opportunity  for  public  comment,
 establishes  one  or  more  definitions  of  such  term  which  are  appropriate  to  the  activities  of  the  agency  and  publishes  such  definition(  s)  in  the  Federal  Register.  5  U.  S.  C.    601(  3).
 79  13  C.  F.  R.    121.201.
 80  5  U.  S.  C.    601(  3).
 81  Letter  from  Jere  W.  Glover,  Chief  Counsel  for  Advocacy,  SBA,  to  William  E.  Kennard,  Chairman,  FCC
 (May  27,  1999).  SBA  regulations  interpret  small  business  concern  to  include  the  concept  of  dominance  on  a  national  basis.  13  C.  F.  R.    121.  102(  b).  Since  1996,  out  of  an  abundance  of  caution,  the  Commission  has  included
 small  incumbent  LECs  in  its  regulatory  flexibility  analyses.  See,  e.  g.,  Implementation  of  the  Local  Competition  Provisions  of  the  Telecommunications  Act  of  1996,  First  Report  and  Order,  CC  Docket  96-  98,  11  FCC  Rcd  15499,
 16144-  45  (1996).
17
 Federal  Communications  Commission  FCC  99-  345
 18
 Communications  Common  Carriers  (  SOCC)  report  as  having  more  than  1,500  employees.  82  Consequently,  we  estimate  that  2  or  fewer  providers  of  local  exchange  service  are  small  price  cap  LECs
 that  may  be  affected  by  these  proposals.
 60.  Description  of  Projected  Reporting,  Recordkeeping  and  Other  Compliance  Requirements.  We  expect  that,  on  balance,  the  proposals  in  this  Notice  will  not  change  price  cap  LECs'  administrative
 burdens  or  cause  price  cap  LECs  to  incur  any  additional  costs  associated  with  proposed  reporting  and  recordkeeping  requirements.  The  studies  discussed  in  Section  III  would  establish  new  X-  factors  that
 price  cap  LECs  would  need  to  utilize  in  their  price  cap  calculations,  but  otherwise  should  not  affect  their  administrative  burdens  or  costs.
 61.  Steps  Taken  to  Minimize  Significant  Economic  Impact  on  Small  Entities,  and  Significant  Alternatives  Considered.  The  RFA  requires  agencies  to  describe  any  significant  alternatives  that  it  has
 considered  in  reaching  its  proposed  approach,  which  may  include  the  following  four  alternatives:  (1)  the  establishment  of  differing  compliance  or  reporting  requirements  or  timetables  that  take  into  account  the
 resources  available  to  small  entities;  (2)  the  clarification,  consolidation,  or  simplification  of  compliance  or  reporting  requirements  under  the  rule  for  small  entities;  (3)  the  use  of  performance  rather  than  design
 standards;  and  (4)  an  exemption  from  coverage  of  the  rule,  or  any  part  thereof,  for  small  entities.  83  In  the  instant  proceeding  we  are  seeking  comment  on  the  prescription  of  the  productivity  offset,  or  X-  factor,
 portion  of  the  price  cap  formula.  Therefore,  only  the  first  and  last  possible  alternatives  listed  in  section  603(  c)  of  the  RFA  would  be  applicable.  In  Section  V  of  the  Notice,  we  seek  comment  on  how  the
 prescription  of  the  X-  factor  would  affect  smaller  price  cap  LECs  differently  from  other  price  cap  LECs,  and  whether  there  should  be  a  separate  X-  factor  calculated  for  smaller  price  cap  LECs.  We  also  do  not
 believe  it  would  be  appropriate  to  exempt  small  price  cap  LECs  from  the  application  of  an  X-  factor.  We  seek  comment  on  these  issues  and  urge  commenting  parties  to  support  their  comments  with  specific
 evidence  and  analysis.
 62.  Federal  Rules  that  May  Duplicate,  Overlap,  or  Conflict  With  the  Proposed  Rules.  None.
 C.  Filing  of  Comments  and  Reply  Comments
 63.  Pursuant  to  Sections  1.415  and  1.419  of  the  Commission's  rules,  47  C.  F.  R.    1.  415,  1.  419,  interested  parties  may  file  comments  on  or  before  December  30,  1999  and  reply  comments  on  or  before
 January  14,  2000.  Comments  may  be  filed  using  the  Commission's  Electronic  Comment  Filing  System  (  ECFS)  or  by  filing  paper  copies.  84
 64.  Comments  filed  through  the  ECFS  can  be  sent  as  an  electronic  file  via  the  Internet  to  <http://  www.  fcc.  gov/  e-  file/  ecfs.  html>.  In  completing  the  transmittal  screen,  commenters  should  include
 their  full  name,  Postal  Service  mailing  address,  and  the  applicable  docket  or  rulemaking  number.  Parties  may  also  submit  an  electronic  comment  by  Internet  e-  mail.  To  get  filing  instructions  for  e-  mail
 comments,  commenters  should  send  an  e-  mail  to  ecfs@  fcc.  gov,  and  should  include  the  following  words
 82  Preliminary  Statistics  of  Communications  Common  Carriers  (1998  ed.)  at  Table  2.9.
 83  5  U.  S.  C.    603(  c)(  1)-(  4).
 84  See  Electronic  Filing  of  Documents  in  Rulemaking  Proceedings,  Report  and  Order,  GC  Docket  No.  97-113,
 13  FCC  Rcd  11322  (1998).
18
 Federal  Communications  Commission  FCC  99-  345
 19
 in  the  body  of  the  message,  get  form  <your  e-  mail  address>.  A  sample  form  and  directions  will  be  sent  in  reply.  Only  one  copy  of  electronically-  filed  comments  must  be  submitted.
 65.  Parties  who  choose  to  file  by  paper  must  file  an  original  and  four  copies  of  each  filing.  All  filings  must  be  sent  to  the  Commission's  Secretary,  Magalie  Roman  Salas,  Office  of  the  Secretary,
 Federal  Communications  Commission,  445  12th  Street,  S.  W.,  Room  TW-  B204,  Washington,  D.  C.  20554.
 66.  Parties  who  choose  to  file  by  paper  should  also  submit  their  comments  on  diskette.  The  diskette  should  be  submitted  to:  Wanda  Harris,  Federal  Communications  Commission,  Common  Carrier
 Bureau,  Competitive  Pricing  Division,  445  12th  Street,  S.  W.,  Fifth  Floor,  Washington,  D.  C.  20554.  The  submission  should  be  on  a  3.5  inch  diskette  formatted  in  an  IBM  compatible  format  using  WordPerfect
 5.1  for  Windows  or  compatible  software.  The  diskette  should  be  accompanied  by  a  cover  letter  and  should  be  submitted  in  read  only  mode.  The  diskette  should  be  clearly  labeled  with  the  commenter's
 name,  proceeding  (including  the  docket  number  in  this  case),  type  of  pleading  (comments  or  reply  comments),  date  of  submission,  and  the  name  of  the  electronic  file  on  the  diskette.  The  label  should  also
 include  the  following  phrase:  Disk  Copy  -  Not  an  Original.  Each  diskette  should  contain  only  one  party's  pleadings,  preferably  in  a  single  electronic  file.  In  addition,  commenters  must  send  diskette  copies
 to  the  Commission's  copy  contractor,  International  Transcription  Service,  Inc.,  1231  20th  Street,  N.  W.,  Washington,  D.  C.  20036.  Comments  and  reply  comments  will  be  available  for  public  inspection  during
 regular  business  hours  in  the  FCC  Reference  Center,  445  12th  Street,  S.  W.,  Room  CY-  A257,  Washington,  D.  C.  20554.
 .VII.  ORDERING  CLAUSES
 67.  Accordingly,  IT  IS  ORDERED  that,  pursuant  to  the  authority  contained  in  Sections  1,  4(  i),  4(  j),  201-  205,  and  303(  r)  of  the  Communications  Act  of  1934,  as  amended,  47  U.  S.  C.    151,  154(  i),  (j),
 201-  205,  and  303(  r),  NOTICE  IS  HEREBY  GIVEN  of  the  rulemaking  described  above  and  that  COMMENT  IS  SOUGHT  on  those  issues.
 68.  IT  IS  FURTHER  ORDERED  that  the  Commission's  Office  of  Public  Affairs,  Reference  Operations  Division,  SHALL  SEND  a  copy  of  this  Further  Notice  of  Proposed  Rulemaking,  including
 the  Initial  Regulatory  Flexibility  Analysis,  to  the  Chief  Counsel  for  Advocacy  of  the  Small  Business  Administration.
 FEDERAL  COMMUNICATIONS  COMMISSION
 Magalie  Roman  Salas  Secretary
19
 Federal  Communications  Commission  FCC  99-  345
 20
 Appendix  A
 Sources  of  Potential  Errors  in  the  1997  Staff  TFP  Study
 Noel  D.  Uri
 A  review  of  the  1997  Staff  TFP  Study,  upon  which  the  Commission  relied  in  its  1997  Price  Cap  Review  Order,  1  has  identified  a  number  of  potential  errors  that  appear  to  affect  significantly  the  results  of
 the  study.  Below  we  discuss  a  possible  conceptual  error  and  a  method  of  correcting  the  problem.  We  then  discuss  three  sources  of  potential  bias  that  are  attributable  to  the  study's  sources  of  data  and  how
 these  potential  biases  can  be  corrected.  Finally,  we  discuss  a  number  of  other  sources  of  possible  bias.  These  possible  biases  either  are  not  easily  quantified,  or  do  not  have  a  significant  impact  on  the  level  of
 the  X-  factor.
 I.  Competitively  Determined  Historical  Cost  of  Capital
 The  1997  Staff  TFP  Study  used  actual  imputed  cost  of  capital  when  measuring  the  productivity  of  regulated  companies.  Several  parties  allege  that  this  creates  a  problem,  because  of  the  use  of  the  residual
 value  approach  for  determining  the  cost  of  the  capital  input.  2  With  this  approach,  the  Commission  in  the  1997  Price  Cap  Review  Order  first  directly  determined  the  price  and  quantity  of  every  input  except
 capital,  i.  e.,  labor  and  materials.  That  is,  it  directly  calculated  the  realized  return  to  every  non-  capital  input.  Next,  based  on  an  estimate  of  the  capital  stock,  the  assumption  that  all  revenue  is  distributed  to  the
 inputs,  3  and  given  the  returns  to  labor  and  materials  based  on  historical  data,  a  cost  of  capital  is  imputed.
 1  Price  Cap  Performance  Review  for  Local  Exchange  Carriers,  Fourth  Report  and  Order  in  CC  Docket
 No.  94-  1  and  Second  Report  and  Order  in  CC  Docket  No.  96-  262,  12  FCC  Rcd  16642  (1997)  ("  1997  Price  Cap  Review  Order").
 2  See  Reply  Comments  of  Ad  Hoc,  CC  Docket  No.  94-  1  at  18  (Nov.  9,  1998)  (arguing  that  the
 Commissions  model,  measuring  the  input  cost  of  capital  as  a  firms  overall  return  on  investment,  does  not  accurately  calculate  the  capital  costs  in  a  market  that  is  not  competitive);  Reply  Comments  of  AT&  T,  CC  Docket
 No.  94-  1  at  19  (Nov.  9,  1998)  (arguing  that  the  Commissions  miscalculated  increase  in  incumbent  LEC  input  prices  is  due  mainly  to  the  huge  surge  in  incumbent  LEC  operating  earnings  in  1996  and  1997);  Reply  Comments  of  MCI,
 CC  Docket  No.  94-  1  at  27-  28  (Nov.  9,  1998)  (arguing  that,  under  the  Commissions  X-  factor  calculation,  higher  earnings  on  the  part  of  LECs  would  actually  suggest  lower  productivity).
 3  The  validity  of  conventional  TFP  models  depends  on  several  assumptions.  Generally,  the  analysis
 assumes  constant  returns  to  scale  and  that  the  market  is  in  competitive  long-  run  equilibrium.  See,  e.  g.,  Ernst  R.  Berndt  &  Melvyn  A.  Fuss,  Productivity  Measurement  with  Adjustments  for  Variations  in  Capacity  Utilization  and
 Other  Forms  of  Temporary  Equilibrium,  33  Journal  of  Econometrics  7  (1986),  and  Dale  W.  Jorgenson  &  Zvi  Griliches,  The  Explanation  of  Productivity  Change,  34  Rev.  Econ.  Stud.  249  (1967).  If  these  assumptions  are  not
 met,  it  may  not  be  appropriate  to  apply  the  results  of  the  analysis  to  set  an  X-  factor.  Note  that  constant  returns  to  scale  exist  if  doubling  all  inputs  causes  output  to  double,  tripling  all  inputs  causes  output  to  triple,  and  so  forth.  See
 Richard  A.  Bilas,  Microeconomic  Theory  120  (1971).  In  some  cases,  modifications  in  the  calculations  can  be  made  to  take  account  of  the  departure  from  the  assumptions  of  the  model.
20
 Federal  Communications  Commission  FCC  99-  345
 21
 Conceptually,  the  difference  (residual)  between  revenue  and  the  required  returns  to  all  non-  capital  inputs  (which  is  just  the  nominal  amount  used  to  impute  a  cost  of  capital)  consists  of  two  parts.  The  first
 part  is  the  required  return  to  capital.  The  second  part  is  the  excess  profit  earned  by  the  firm.  Instead  of  attempting  to  separate  this  difference  into  two  parts,  the  Commission  in  the  1997  Price  Cap  Review  Order
 assumed  that  all  of  this  residual  was  the  required  return  to  capital,  i.  e.,  that  no  excess  profit  was  earned.  This  is  a  reasonable  assumption  for  a  competitive  market,  and  even  for  non-  competitive  markets,  as  long
 as  the  goal  of  the  study  is  simply  to  measure  the  productivity  gains  revealed  by  market  forces.  4  In  a  regulatory  setting,  however,  the  productivity  gains  are  "revealed"  by  the  application  of  the  X-  factor,  not
 by  market  forces.
 By  attributing  all  of  the  residual  to  the  capital  inputs,  the  residual  value  method  tends  automatically  to  define  whatever  profits  or  losses  the  LECs  realized  during  the  historical  period  as
 increases  or  decreases  in  the  cost  of  capital  inputs.  Critics  contend  that  if,  for  example,  the  Commission  chose  too  low  an  X-  factor  during  the  historical  period  being  considered,  causing  the  LECs'  profits  to
 increase,  the  residual  value  method  would  indicate  that  the  historical  cost  of  LEC  capital  inputs  rose  more  rapidly  during  this  period  than  it  actually  did.  The  Commission  then  would  predict  an  equally  large
 growth  in  LEC  capital  cost  in  the  future,  and  thus  calculate  an  X-  factor  that  was  still  too  low.  5  Consequently,  critics  contend  that  LECs'  profits  would  continue  to  increase  despite  no  increase  in  LEC
 productivity.  On  the  other  hand,  suppose  that  the  Commission  chose  too  high  an  X-  factor  during  the  historical  period,  causing  LECs'  profits  to  decrease.  Critics  contend  that  the  residual  value  method  would
 indicate  that  the  historical  cost  of  LEC  capital  inputs  fell  more  rapidly  during  this  period  than  it  actually  did.  The  Commission  then  would  predict  an  equally  large  price  reduction  for  capital  in  the  future,  and
 thus  calculate  an  X-  factor  that  was  still  too  high.  Consequently,  LECs'  profits  would  continue  to  decrease  despite  no  decrease  in  LEC  productivity.  In  either  scenario,  critics  claim,  the  LECs'  productivity  remains
 constant;  only  their  rate  of  return  is  affected  by  the  incorrect  X-  factor.  Thus,  they  assert  that  the  residual  value  method  produces  an  X-  factor  that  is  biased  in  the  same  direction  as  whatever  bias  existed  in  the
 historical  period.
 Accordingly,  the  critics  theory  posits  that,  to  avoid  this  problem,  any  TFP  study  of  a  regulated  industry  should  augment  or  reduce  the  actual  amounts  of  capital  compensation  in  such  a  way  as  to
 duplicate  the  forces  of  a  competitive  market.  USTA  proposed  an  index  similar  to  the  one  we  are  using.  6  What  USTA  did  not  do  is  reduce  the  revenue  as  capital  compensation  went  down.  To  capture  the  gains  in
 productivity  that  would  have  been  revealed  in  a  competitive  marketplace,  total  capital  compensation  must  vary  with  the  competitive  capital  compensation  rate.
 In  order  to  correct  the  alleged  miscalculation  of  the  LECs'  cost  of  capital  in  the  1997  Staff  TFP  study,  it  is  necessary  to  replace  the  TFP  study's  cost  of  capital  with  a  competitive  cost  for  the  inputs
 4  Dale  W.  Jorgenson  &  Zvi  Griliches,  The  Explanation  of  Productivity  Change,  34  Rev.  Econ.  Stud.  249-283
 (1967).
 5  One  component  of  the  X-  factor  calculation  is  the  difference  between  the  US  Economy's  average  input
 costs  and  the  historical  input  costs  of  LECs.  Thus,  an  artificially  high  LEC  capital  input  cost  would  lead  to  an  artificially  low  X-  factor.
 6  Letter  from  Mary  McDermott,  Vice  President    Legal  &  Regulatory  Affairs,  USTA,  to  William  F.
 Caton,  Acting  Secretary,  FCC,  Jan.  20,  1995,  Attachment  at  11.
21
 Federal  Communications  Commission  FCC  99-  345
 22
 during  the  historical  years.  Next,  it  is  necessary  to  adopt  a  surrogate  to  emulate  a  competitive  cost  of  capital  for  LECs  because  LECs  have  never  operated  in  a  competitive  market.  This  study  employs  an
 independent  price  series  to  compute  the  annual  change  in  the  cost  of  capital  for  a  competitive  market.  7  Specifically,  Moody's  Baa  corporate  bond  rate  reported  in  the  1999  Economic  Report  of  the  President
 (Table  B-  73)  is  used  to  calculate  the  adjustment.  8  Combining  the  base  year  9  imputed  cost  of  capital  from  the  1997  staff  TFP  study  with  the  change  in  the  competitive  cost  of  capital  gives  an  independent
 competitive  cost  of  capital  for  LECs  in  each  year  of  the  historical  period.  This  competitive  cost  of  LECs'  capital  input  is  used  in  conjunction  with  an  adjusted  cost  of  labor  (see  below)  and  materials  inputs  from
 the  1997  staff  TFP  study,  as  well  as  the  percent  change  in  the  U.  S.  nonfarm  business  sector  input  price  growth,  to  compute  the  corrected  input  price  differential  portion  of  the  historical  X-  factor.  10
 Recalculating  the  LECs'  historical  cost  of  capital  changes  the  level  of  the  LECs'  revenues,  taxes,  and  operating  expenses  for  the  historical  years.  If  we  take  the  difference  between  our  estimate  of  the
 competitive  cost  of  LECs'  capital  inputs  and  the  imputed  cost  from  the  1997  staff  TFP  study,  we  obtain  an  estimate  of  the  excess  profits  realized  by  LECs  for  each  year  of  the  historical  period.  11  Reducing  the
 LECs'  total  revenue  by  this  amount  results  in  a  revenue  stream  that  emulates  what  LECs  would  have  realized  in  a  competitive  market.  A  reduction  in  revenue  implies  a  reduction  in  taxes,  12  which  in  turn
 reduces  operating  expenses.  13
 Reducing  LEC  revenues  to  what  would  have  been  realized  in  a  competitive  market  also  changes  the  LECs'  TFP  portion  of  the  X-  factor.  The  new  revenue  level  changes  the  LECs'  input  growth  rate  by
 7  Following  standard  financial  economics  convention,  the  absolute  magnitude  of  the  change  in  the
 independent  price  series  is  used  in  deference  to  the  relative  change.
 8  Any  index  for  a  competitively  determined  cost  of  capital  should  be  acceptable  because  changes  in  the
 cost  of  capital  in  competitive  markets  is  similar  across  markets.  The  use  of  a  different  series  would  yield  comparable  results  given  the  competitive  nature  of  financial  markets.  For  example,  the  correlation  over  the  period
 1985-  1998  between  Moody's  Aaa  corporate  bond  rate  and  the  Baa  rate  used  is  0.  99.  Analogously,  the  correlation  between  the  10-  year  U.  S.  Treasury  securities  rate  and  the  30-  year  U.  S.  Treasury  securities  rate  and  Moody's  Baa  rate
 over  the  same  period  is  0.99  and  0.98,  respectively.  In  terms  of  changes  in  the  absolute  level  of  the  series,  the  correlation  between  Moody's  Baa  corporate  bond  rate  and  Moody's  Aaa  corporate  bond  rate,  the  10-  year  U.  S.
 Treasury  securities  rate,  and  the  30-  year  U.  S.  Treasury  securities  rate  over  the  period  1985-  1998  is  0.  99,  0.  98,  and  0.97,  respectively.
 9  The  base  year  is  1991.  This  is  the  first  full  year  of  LEC  price  cap.  We  are  assuming  that  LEC  returns  on
 capital  for  this  year  were  at  a  competitive  level.  That  is,  it  is  assumed  that  LECs  earned  a  normal  return  in  that  year.
 10  This  results  of  this  calculation  is  found  in  column  H  of  Table  B-  12  in  Appendix  B.  Note  that  in  the  1997
 staff  TFP  study,  we  estimated  the  U.  S.  nonfarm  business  input  price  for  1995  because  the  data  were  unavailable  at  that  time.  In  this  Notice,  because  the  data  are  now  available,  we  use  the  actual  1995  value.
 11  The  LECs'  excess  profits  are  due  to  their  output  prices  falling  slower  than  their  cost  of  capital  during  the
 historical  years.  This  situation  would  not  have  occurred  in  a  competitive  market.
 12  Following  standard  Commission  procedures  we  assume  that  taxes  are  39  percent  (34  percent  federal  and
 5  percent  state).
 13  Taxes  are  one  component  of  operating  expenses.
22
 Federal  Communications  Commission  FCC  99-  345
 23
 altering  the  relative  share  of  revenue  accounted  for  by  each  input:  14  labor,  materials,  and  capital.  15  In  other  words,  the  LECs'  input  growth  rate  changes  in  response  to  the  changes  in  the  relative  weight  of  each
 input  factor.  16  Combining  the  output  growth  rate  from  the  1997  staff  TFP  study  with  the  revised  LECs'  input  growth  rate  yields  the  corrected  TFP  growth  rate  for  the  LECs.  17
 II.  Other  Modifications  to  the  1997  Staff  TFP  Study
 In  addition  to  updating  the  data  for  the  period  1996-  1998,  the  study  concludes  that  a  number  of  adjustments  to  the  study  reasonably  could  be  performed  to  improve  the  1997  Staff  TFP  Studys  accuracy.
 First,  we  could  substitute  the  recently  revised  BLS  series  on  multifactor  productivity  for  the  series  previously  employed.  18  In  addition,  our  recalculation  of  the  X-  factor  could  adjust  for  potential  biases  in
 the  local  service  output  index  and  the  price  of  labor.  These  adjustments  are  easily  quantified  and  are  likely  to  have  a  significant  impact  on  the  level  of  the  recalculated  X-  factor.
 The  potential  bias  in  the  LECs'  local  output  index  would  affect  the  LEC's  TFP.  The  local  service  output  index  from  the  1997  staff  TFP  study  was  based  on  the  number  of  local  calls.  Because  the  length  of
 calls  can  vary  significantly,  however,  basing  the  LECs'  local  output  index  on  the  number  of  dial  equipment  minutes  (DEMs)  more  accurately  measures  the  use  of  the  LECs'  local  equipment.  For  much  of
 the  period  beginning  in  1985,  the  average  length  of  a  local  call  measured  by  the  number  of  local  DEMs  divided  by  the  number  of  local  calls  was  approximately  constant.  Beginning  in  1992,  however,  there  is  a
 pronounced  upward  trend  in  local  call  length.  This  trend  is  attributable  in  large  part  to  the  increase  in  the  use  of  the  Internet  by  local  subscribers.  This  increase  has  important  implications  for  measuring  local
 output  and,  in  turn,  LECs'  TFP.  Using  the  number  of  local  calls  as  the  output  measure,  output  increased  between  1992  and  1997  at  a  3.5  percent  annual  rate.  On  the  other  hand,  using  the  number  of  DEMs  as  the
 local  output  measure,  output  increased  at  a  6.5  percent  annual  rate.
 14  Note  that,  in  using  shares  to  aggregate  inputs,  the  1997  staff  TFP  study  introduced  another  source  of
 bias.  Namely,  the  observed  shares  were  not  cost  minimizing  shares  (i.  e.,  the  factors  are  not  paid  the  value  of  their  marginal  products  as  assumed  in  the  TFP  approach).  The  correction  makes  an  adjustment  for  this  bias.
 15  Our  recalculation  does  not  change  the  labor  and  capital  input  quantities  indexes.  The  materials  input
 index,  however,  (computed  as  the  total  operating  expenses  minus  labor  compensation,  depreciation,  and  amortization),  changes  when  the  operating  expenses  are  reduced.
 16  The  change  in  relative  weights  means  that  the  weights  used  in  computing  the  LECs'  input  price  growth
 must  be  recomputed  which,  in  turn,  implies  a  recomputation  of  LECs'  excess  profits,  etc.  This  an  iterative  process.  The  new  LEC  input  growth  rate  is  found  in  column  C  of  Table  B-  12  in  Appendix  B.
 17  The  difference  between  the  LECs'  TFP  growth  rate  and  the  growth  rate  of  the  TFP  for  the  U.  S.  nonfarm
 business  section  is  in  column  E  of  Table  B-  12  in  Appendix  B.  The  1997  staff  TFP  study  approximated  the  U.  S.  nonfarm  business  sector  TFP  value  for  1995  because  the  actual  data  were  not  available  at  that  time.  Since  these  data
 are  now  available,  we  update  these  data  using  the  Bureau  of  Labor  Statistics  revision  of  the  entire  multifactor  productivity  series  dating  back  to  1985.
 18  The  nature  of  this  update  in  the  BLS  multifactor  productivity  series  is  discussed  in  John  Duke  &  Lisa
 Usher,  BLS  Completes  Major  Expansion  of  Industry  Productivity  Series,  121  Monthly  Lab.  Rev.,  35-  51  (1998).  The  specific  series  used  was  obtained  from  the  Bureau  of  Labor  Statistics  web  site  (www.  bls.  gov)  for  multifactor
 productivity.  The  annual  series  is  from  Table  2:  Private  Nonfarm  business:  Productivity  and  related  indexes,  1948-  97.
23
 Federal  Communications  Commission  FCC  99-  345
 24
 Because  the  data  are  not  yet  available,  it  is  necessary  to  forecast  two  1998  values  used  in  computing  the  X-  factor  -  the  number  of  local  dial  equipment  minutes  and  the  multifactor  productivity.
 Local  dial  equipment  minutes  for  1998  are  forecast  using  an  extrapolation  of  the  average  rate  of  growth  in  dial  equipment  minutes  beginning  in  1992.  19  The  multifactor  productivity  value  for  1998  was  forecast
 using  a  structural  model  relating  the  natural  logarithm  of  the  multifactor  productivity  to  the  natural  logarithm  of  the  output  of  all  persons  employed.  20  This  second  series  is  reported  by  the  Bureau  of  Labor
 Statistics,  and  its  value  for  1998  is  available.  The  parameter  estimates  of  the  structural  model  in  conjunction  with  the  1998  value  for  output  per  hour  of  all  persons  employed  gives  the  forecast  of  1998
 multifactor  productivity.
 Another  adjustment  we  could  make  concerns  the  price  of  labor.  This  problem  has  further  implications  because  labor's  share  of  total  factor  payments  will  be  inflated  relative  to  the  other  factors  of
 production.  Between  1985  and  1998,  the  price  of  labor,  defined  as  the  average  compensation  per  employee,  21  increased  in  real  terms  at  a  3.6  percent  annual  rate.  In  terms  of  total  compensation,  the
 amount  paid  for  labor  was  approximately  the  same  in  1985  as  it  was  in  1998  even  though  the  number  of  workers  in  the  aggregate  had  been  reduced  by  over  30  percent.  The  reason  for  this,  at  least  in  part,  is  that,
 coincident  with  the  adoption  of  price  cap  plans,  labor  force  reductions  were  accomplished  by  offering  employees  monetary  incentives  to  leave  the  company  (i.  e.,  buyouts).  There  is  some  variability  in  the
 applicable  accounting  rules,  22  but  these  payments  were  generally  accrued  as  one-  time  charges  against  current  earnings.  23  This  will  tend  to  inflate  costs  in  the  early  years  after  the  implementation  of  price  caps
 and,  in  turn,  bias  the  measure  of  TFPLEC  growth  downward  for  these  periods.  24
 The  resulting  recalculation  of  the  X-  factor,  in  which  we  use  a  competitively  determined  cost  of  capital,  update  the  multifactor  productivity  series,  substitute  a  better  measure  than  the  number  of  calls  for
 19  Data  beginning  in  1985  could  have  been  used  in  fitting  the  functional  relationship  used  to  produce  the
 forecast.  Because  there  was  an  identifiable  structural  change  in  the  data  series  beginning  in  1992,  taking  account  of  this  structural  change  would  yield  a  model  equivalent  to  that  based  on  data  beginning  in  1992.  The  coefficient  of
 determination  for  the  estimated  model  was  0.  97.
 20  Regression  diagnostics  indicated  that  1991  was  an  outlier.  A  dummy  variable  was  inserted  to  capture
 the  effects  of  this.  The  coefficient  of  determination  on  the  fitted  model  was  0.  88.
 21  The  average  compensation  per  employee  is  equal  to  total  labor  compensation  divided  by  the  number  of
 employees.
 22  See,  e.  g.,  Financial  Accounting  Standards  Board  Rule  (FASB)  Number  106.
 23  Donald  J.  Kridel  et  al.,  The  Effects  of  Incentive  Regulation  in  the  Telecommunications  Industry:  A
 Survey,  9  J.  Reg.  Econ.  269-  306  (1996).
 24  The  cost  of  labor  input  (management  and  non-  management)  in  the  1997  Price  Cap  Review  Order  is
 equal  to  wages  and  salaries  expenses  plus  benefits  expenses.  This  suggests  that  the  lump-  sum  incentive  payments  would  be  recorded  as  labor  costs.  A  key  issue  is  a  measurement  problem  since  accounting  data  do  not  reflect  the
 real  cost  accurately.  To  the  extent  that  direct  observations  on  labor  input  (i.  e.,  actual  hours  worked)  are  used,  however,  any  disparities  between  accounting  costs  and  real  costs  could  be  avoided.  Unfortunately,  labor  input  is  not
 measured  by  the  number  of  hours  worked  but  as  the  total  number  of  employees.
24
 Federal  Communications  Commission  FCC  99-  345
 25
 local  output,  and  adjust  the  price  of  labor  to  reduce  the  effects  of  buyouts,  is  presented  in  Table  B-  12  in  Appendix  B.
 While  we  have  identified  other  potential  sources  of  bias  from  the  1997  Price  Cap  Order  in  our  proposed  recalculation  of  the  X-  factor,  the  1999  staff  TFP  study  does  not  adjust  for  them  because  they
 either  are  not  easily  quantified,  or  do  not  have  a  significant  impact  on  the  level  of  the  X-  factor.  These  other  possible  sources  of  bias  are  discussed  below.
 III.  Other  Possible  Sources  of  Bias
 The  productivity  offset  or  X-  factor  is  given  as
 X(  H)  =  (%_  TFPLEC(  H)  -  %_  TFPUS(  H))  +  (%_  IPUS(  H)  -  %_  IPLEC(  H))
 where  X(  H)  denotes  the  historical  X-  factor,  %_  TFPLEC(  H)  denotes  the  percent  change  in  the  historical  total  factor  productivity  of  local  exchange  carriers  between  period  t-  1  and  t,  25  %_  TFPUS(  H)  denotes  the
 percent  change  in  the  historical  total  factor  productivity  for  the  entire  U.  S.  economy  between  period  t-  1  and  t,  %_  IPUS  denotes  the  percent  change  in  the  historical  input  prices  of  all  goods  and  services  used  to
 produce  output  of  goods  and  services  in  the  United  States  between  period  t-  1  and  t,  and  %_  IPLEC  denotes  the  percent  change  in  the  historical  input  prices  of  local  exchange  carriers  used  to  produce  local  service,
 intrastate  toll/  access  service,  and  interstate  service  between  period  t-  1  and  t.
 It  is  important  to  note  that  there  is  no  debate  about  whether  there  is  appropriately  an  X-  factor  in  the  price  cap  equation  nor  is  there  a  question  about  whether  an  input  price  differential  should  properly  be
 included  in  the  specification.  The  issue  at  hand  is  whether  the  components  of  the  X-  factor  are  accurately  measured  based  on  the  data  actually  used  in  the  computation.  An  assessment  of  this  is  the  focus  of  what
 follows.
 A.  Biases  in  the  Measurement  of  TFPLEC
 There  are  a  number  of  biases  inherent  in  the  measurement  of  TFPLEC.  There  are  general  biases  and  data-  specific  biases  which  will  tend  to  overestimate  or  underestimate  the  true  value  of  TFPLEC.
 i.  General  Biases
 First,  TFPLEC  will  be  biased  since  it  is  not  compatible  with  incentives  to  be  economically  efficient  because  the  disaggregated  input  and  output  data  are  under  the  control  of  the  regulated  LECs  and,  thus,  are
 subject  to  manipulation.  It  has  been  noted  that  price  cap  regulation  has  the  potential  to  introduce  pure  waste,  inefficient  factor  utilization,  excessive  research  and  development  expenses,  and  over-  investment  in
 demand  increasing  expenditures.  26  This  will  bias  the  measurement  of  TFPLEC  downward.  The  extent  of
 25  Note  that  the  time  period  subscripts  are  suppressed  in  order  to  facilitate  the  exposition.
 26  David  E.  M.  Sappington,  Strategic  Firm  Behavior  Under  a  Dynamic  Regulatory  Adjustment  Process,  11
 Bell  J.  Econ.  360-  72  (1980).  Among  the  strategies  identified  by  a  firm  to  enhance  long-  run  profits  is  the  purchase  of  inputs  that  have  no  productive  value.  Other  strategies  include  the  acquisition  of  perquisites  for  executives  of  the
 firm,  the  employment  of  factors  of  production  in  inefficient  combinations,  and  the  allocation  of  excess  funds  to  research  and  development.
25
 Federal  Communications  Commission  FCC  99-  345
 26
 this  downward  bias  will  be  a  function  of  the  quantitative  magnitude  of  any  excessive  expenditures  and  inefficient  factor  utilization.  27
 Another  general  bias  introduced  in  the  measurement  of  TFPLEC  is  associated  with  the  use  of  LEC  performance  data  immediately  post-  divestiture.  This  will  give  a  downward  bias  to  the  measure.  It  is
 generally  conceded  that  under  rate-  of-  return  (ROR)  regulation,  regulated  firms  employed  too  much  capital  and  too  much  labor.  Transition  from  the  regulated  environment  is  not  instantaneous.  The  optimal
 level  of  factors  of  production  will  be  in  disequilibrium  for  some  period  of  time  following  the  demise  of  ROR  regulation.  Hence,  the  measured  TFPLEC  as  reported  in  the  1997  Price  Cap  Review  Order  will
 contain  some  disequilibrium  periods.  28  That  is,  the  measurement  of  the  productivity  of  LECs  is  necessarily  calculated,  at  least  partially,  in  a  ROR  environment  which  will  bias  downward  the  TFP
 measure  for  at  least  a  portion  of  the  period.
 A  final  general  bias  introduced  in  the  measurement  of  TFPLEC  is  associated  with  the  demand  for  interstate  access  to  local  LECs'  local  loops.  Interstate  access  service  is  the  focus  of  price  cap  regulation.
 It  has  grown  much  more  rapidly  on  average  than  demand  for  local  service  and  intrastate  access  service.  The  data  on  this  are  clear.  Thus,  in  the  presence  of  economies  of  density,  29  this  leads  to  the  conclusion
 that  TFPLEC  in  interstate  services  has  grown  faster  than  company-  wide  (regulated)  TFPLEC.  30  More  specifically,  the  price  cap  index  (PCI)  being  considered  here  applies  to  interstate  access  service  but
 TFPLEC  is  computed  based  on  all  LEC  services.  There  is  every  reason  to  expect  that  productivity  enhancements  experienced  historically  in  the  interstate  access  market  would  be  substantially  greater  than
 the  overall  rate  of  productivity  growth  experienced  by  LECs  in  supplying  all  services.  First,  most  of  the  productivity  growth  experienced  in  the  telecommunications  industry  is  related  to  reductions  in  switching
 costs  and  to  savings  in  transmissions  costs  which  occur  as  a  result  of  using  electronics  to  expand  the  carrying  capacity  of  transmissions  facilities.  In  contrast  productivity  growth  in  supplying  loop  services
 has  been  relatively  lower.  As  a  result  of  this,  the  average  measure  of  TFPLEC  used  in  setting  X  and  which  should  properly  reflect  productivity  growth  in  the  interstate  access  market  is  biased  downward.
 ii.  Data-  Specific  Biases
 a.  Output  Biases
 27  This  goes  directly  to  the  argument  that  an  accurate  measurement  of  TFPLEC  should  not  be  used  to  adjust
 prices  directly  since  full  contemporaneous  adjustment  would  diminish  the  LEC's  incentive  to  conserve  costs  and  operate  efficiently.  A  full  consideration  of  this  issue,  however,  is  outside  the  scope  of  the  present  discussion.
 28  An  important  assumption  underlying  any  computation  of  TFP  is  that  all  inputs  (factors  of  production)
 are  in  full  static  equilibrium.  In  many  instances  for  local  exchange  carriers,  however,  the  assumption  of  full  static  equilibrium  is  suspect  and  hence,  so  are  the  empirical  results.  Additionally,  departures  from  full  static  equilibrium
 may  result  from  factors  other  than  internal  adjustment  costs.  In  the  case  of  LECs,  there  is  no  evidence  that  capital  stocks,  for  example,  are  completely  adjusted  at  all  times  to  cost-  minimizing  levels.
 29  Economies  of  density  are  a  type  of  economies  of  scale  that  result  in  a  decrease  in  unit  cost  of  service  that
 results  from  more  intensive  use  of  an  existing  facility's  capacity.
 30  Richard  T.  Shin  &  John  S.  Ying,  Costly  Gains  to  Breaking  Up:  LECs  and  the  Baby  Bells,  98  Rev.  Econ.
 &  Stat.  357-  61  (1993).
26
 Federal  Communications  Commission  FCC  99-  345
 27
 We  turn  now  to  specific  issues  involving  the  measurement  of  TFPLEC.  It  is  generally  recognized  that  output  growth  is  a  key  determinant  of  the  rate  of  growth  of  TFP.  Thus,  it  is  especially  important  to
 measure  it  as  precisely  as  possible.
 Characterizing  output  is  not  a  trivial  undertaking.  Output  of  telephone  service  includes  both  access  and  use.  Access  and  use,  however,  are  complicated  by  access  and  use  externalities.  The  presence
 of  these  externalities  means  that,  contrary  to  what  is  typically  presumed,  preferences  are  interdependent  across  subscribers.  That  is,  as  more  users  gain  access  to  telephone,  the  utility  of  customers  in  the
 aggregate  rises.  These  externalities  are  exceedingly  difficult  to  quantify  and  are  not  measured  here.  This  will  bias  downward  the  TFPLEC  measure.  Additionally,  output  comes  in  a  variety  of  forms  including  type
 (station,  person,  collect,  etc.),  time-  of-  day,  day  of  week,  distance,  and  duration.  31
 In  the  specification  used,  total  company  output  consists  of  three  identifiable  components:  local  service,  intrastate  toll/  access  service,  and  interstate  service.  Revenue  shares  are  used  to  weight  each
 component's  contribution  to  total  output.
 Each  of  the  components  in  total  company  output  is  measured  differently.  This  was  dictated  by  the  available  data.  It  introduces  a  potential  source  of  bias.  The  nature  and  extent  of  this  bias,  however,  is
 indeterminate.  That  is,  it  is  not  clear  whether  there  will  be  a  positive  or  negative  bias.  This  is  an  empirical  issue.  Since  comparable  measures  are  not  available  for  each  of  the  output  components,  it  is  not  possible
 to  measure  it  empirically.
 The  local  service  output  measure  is  based  on  the  number  of  local  calls.  Intrastate  service  output  index  is  based  just  on  the  number  of  dial  equipment  minutes  (DEMs)  while  the  interstate  service  output
 index  is  a  function  the  number  of  access  lines,  the  number  of  switched  access  minutes,  and  the  number  of  special  access  lines.  No  measure  of  special  access  minutes  is  used.  It  is  interesting  to  note  that  the
 interstate  output  index  endeavors  to  capture  both  the  access  and  use  components  of  interstate  output.  Output  measures  for  local  service  and  intrastate  service  do  not  endeavor  to  do  so.
 The  component  of  the  output  measure  that  is  probably  the  most  questionable  in  the  1997  Price  Cap  Review  Order  is  the  local  service  output  index.  This,  however,  has  been  corrected  in  the  updated
 study.
 b.  Input  Biases
 We  next  consider  the  input  (factors  of  production)  side  of  measuring  TFPLEC.  Before  doing  so,  however,  it  is  important  to  note  that  the  cost  of  inputs  (i.  e.,  the  prices  paid  for  inputs)  in  the  TFPLEC
 measurement  also  appear  in  the  measurement  of  %_  IPLEC.  Hence,  observations  made  concerning  measurement  errors  and  their  impact  on  the  computed  value  of  TFPLEC  are  equally  applicable  to  the
 measurement  of  the  percentage  change  in  input  prices  of  LECs.  Furthermore,  the  nature  of  the  relationship  given  by  equation  (1)  means  that  most  measurement  errors  associated  with  the  prices  of  the
 inputs  will  tend  to  cancel  out  so  that  the  impact  on  the  productivity  offset  will,  in  general,  be  minimal.
 31  Lester  D.  Taylor,  Telecommunications  Demand  in  Theory  and  Practice  (1994).
27
 Federal  Communications  Commission  FCC  99-  345
 28
 The  most  problematic  input  measure  is  that  for  the  quantity  of  labor.  Measurement  of  each  input  in  a  total  factor  productivity  study  typically  requires  subaggregation  of  various  types  of  the  factor.  In  the
 case  of  labor  this  would  include  several  different  occupational  groups  and  skill  levels  and  would  be  calibrated  as  the  number  of  hours  worked  with  appropriate  adjustments  for  overtime  and  part-  time
 workers.  The  labor  quantity  measure  used  in  the  1997  Price  Cap  Review  Order  consists  solely  of  the  total  number  of  full-  time  employees  of  RBOCs.  Thus,  inherent  productivity  differentials  between
 employees  based  on  such  things  as  skill  levels  is  not  reflected.  If  the  LECs  were  in  equilibrium  such  that  the  relative  proportion  of  employees  in  the  different  occupational  groups  with  defined  skill  levels
 characteristic  of  LECs  remained  unchanged  as  did  the  average  number  of  hours  each  employee  worked,  then  there  would  be  little  concern  over  how  the  labor  variable  is  measured.  This  is  not  the  case,  however.
 Between  1985  and  1998,  there  was  been  a  significant  change  in  the  number  of  employees.  The  LECs  labor  force  declined  by  2.4  percent  annually  over  this  period.  Moreover,  the  reduction  has  taken  place  so
 that  the  number  of  managers  has  been  reduced  disproportionately  more  than  the  number  of  technical  employees.  Thus,  there  is  a  disparity  between  the  change  in  observed  labor  versus  effective  labor.  32  The
 latter  is  what  should  be  included  in  the  measurement  of  TFPLEC  while  the  former  is  what  has  been  included.  Correct  measurement  of  the  labor  variable  would  reduce  aggregate  labor  expenses  and  hence
 increase  TFPLEC.  Hence,  as  constructed,  TFPLEC  is  biased  downward  due  to  the  incorrect  measurement  of  the  number  of  units  of  labor.
 Materials  quantity  and  materials  expense  are  computed  as  residuals.  Materials  quantity  is  equal  to  materials  expense  divided  by  materials  price.  Materials  expense  is  defined  to  equal  total  adjusted
 operating  expense  minus  the  sum  of  labor  compensation,  depreciation,  and  amortization  expense.  The  increase  in  materials  expense  account  for  the  major  portion  of  the  increase  in  total  factor  payment  over
 the  period  1985  to  1998.  It  is  unclear  whether  there  is  a  superior  approach  for  measuring  materials  quantities  and  materials  expense.  The  nature  of  any  TFPLEC  measurement  bias  is  uncertain.
 The  measurement  of  capital  stock  and  the  cost  of  capital  was  of  greatest  concern  in  the  1997  Price  Cap  Review  Order.  Accurate  measurement  of  capital  stock  is  exceedingly  difficult.  Different  types
 of  capital  with  different  vintages  and  technology  comprise  the  stock  in  any  given  period.  This  stock,  moreover,  is  subject  to  different  utilization  rates.  With  these  difficulties  come  two  significant  problems  33
 in  the  development  of  the  measures  of  capital  and  the  cost  of  capital  that  potentially  serve  to  bias  downward  the  reported  measure  of  TFPLEC.  The  first  involves  the  changing  quality  of  capital  over  the
 historical  period  that  is  not  adequately  reflected  in  the  computations.  The  second  involves  changes  in  capacity  utilization  that  are  not  captured.
 The  quantity  of  capital  is  measured  for  each  depreciable  asset  by  the  perpetual  inventory  method  from  data  on  investment.  Many  types  of  capital  inputs  used  by  LECs  have  changed  including  computer
 chips,  digital  electronics,  fiber  optics,  and  digital  switching  equipment.  This  change  in  the  quality  of  capital  is  not  effectively  reflected  in  the  perpetual  inventory  approach  adopted  because  the  output
 associated  with  one  unit  of  new  capital  brought  on  line  is  not  necessarily  equivalent  to  the  output  of  one  unit  already  in  operation.  If  they  are  different,  there  has  been  a  change  in  quality.  The  typical  approach
 32  A  discussion  of  this  concept  is  included  in  Barbara  J.  Craig  et  al.,  International  Productivity  Patterns:
 Accounting  for  Input  Quality,  Infrastructure,  and  Research,  79  Am.  J.  Agric.  Econ.  1064-  76  (1997).
 33  This  is  in  addition  to  the  one  previously  addressed  involving  the  use  of  a  competitively  determined  cost
 of  capital.
28
 Federal  Communications  Commission  FCC  99-  345
 29
 to  reflecting  this  quality  change  is  to  adjust  the  cost  of  capital  downward  to  avoid  understating  the  change  in  the  effective  level  of  real  capital  stocks.  34  Additionally,  to  the  extent  that  succeeding  generations  of
 capital  equipment  are  more  productive,  an  appropriate  adjustment  to  reflect  this  increases  the  computed  level  of  capital  stock,  increases  the  flow  of  capital  services,  and,  holding  output  constant,  decreases  the
 measured  TFPLEC.  Since  there  was  no  quality  adjustment  in  the  computations  reported  in  the  1997  Price  Cap  Review  Order,  TFPLEC  will  be  biased  upward.
 The  second  significant  omission  is  the  failure  to  adjust  for  changes  in  capacity  utilization.  Over  time  as  the  existing  capital  stock  is  used  more  intensively,  output  is  higher  without  a  corresponding
 increase  in  capacity.  35  Consequently,  TFPLEC  is  greater.  There  is,  however,  no  adjustment  for  a  change  in  capacity  utilization  in  the  report.  TFPLEC  will,  consequently,  be  biased  downward.
 B.  Biases  in  the  Measurement  of  TFPUS
 The  measure  of  TFPUS  used  is  the  Bureau  of  Labor  Statistics'  estimate  of  Nonfarm  Business  Sector  Multifactor  Productivity.  36  There  is  concern  that  this  measure  underestimates  the  growth  in  TFPUS.
 There  is,  however,  no  basis  for  determining  the  magnitude  of  the  underestimation  although  the  consensus  is  that  it  is  relatively  small.  37  This  being  the  case,  while  the  productivity  offset  will  be  overestimated,  its
 size  is  small  but  indeterminate.
 The  major  issues  related  to  the  BLS  measure  of  productivity  that  potentially  give  rise  to  overestimation  of  TFPUS  include:
 (1)  Mismeasurement  of  productivity  growth  in  the  services  portion  of  the  economy.  This  portion  of  the  economy  is  defined  to  include  communications.  The  problem  centers  on  how  to  define  output  in  the
 service-  producing  industries.  In  the  case  of  the  services  provided  by  LECs,  this  can  be  thought  of  as  measuring  output  in  terms  of  access  and  use.  There  is  an  enormous  literature  on  the  mechanics  of
 defining  output  in  these  service-  producing  industries  although  there  is  no  consensus  on  how  this  should  be  done.  Inadequate  definitions  of  output  underlie  the  published  data  for  many  service  activities.
 (2)  Biases  in  the  Consumer  Price  Index  (CPI)  on  productivity  data.  Components  of  the  CPI  are  used  to  construct  approximately  57  percent  of  the  business  sector  output  measure  used  for  BLS  productivity
 statistics.  Thus,  any  biases  in  constructing  the  CPI  are  directly  reflected  in  TFPUS.  Biases  in  the  CPI  are  well  documented  although  their  precise  magnitude  is  subject  to  debate.  38  These  biases  include  incorrectly
 34  Jack  E.  Triplett,  High-  Tech  Industry  Productivity  and  Hedonic  Prices,  Industry  Productivity,  OECD,
 119-  42  (Paris,  1996).
 35  Ernst  R.  Berndt  &  Melvyn  A.  Fuss,  Productivity  Measurement  with  Adjustments  for  Variations  in
 Capacity  Utilization  and  Other  Forms  of  Temporary  Equilibrium,  33  J.  Econometrics  7-  29  (1986).
 36  Note  that  the  Bureau  of  Labor  Statistics  refers  to  total  factor  productivity  as  multifactor  productivity.
 37  Edwin  R.  Dean,  The  Accuracy  of  the  BLS  Productivity  Measures,  122  Monthly  Lab.  Rev.  24-  34  (1999).
 38  See,  for  example,  Toward  a  More  Accurate  Measure  of  the  Cost  of  Living,  Final  Report  to  the  Senate
 Finance  Committee  from  the  Advisory  Commission  to  Study  the  Consumer  Price  Index,  U.  S.  Senate  Committee  on  Finance,  (Dec.  1996).
29
 Federal  Communications  Commission  FCC  99-  345
 30
 reflecting  the  substitution  bias  where  consumers'  tendencies  to  substitute  among  items  or  categories  of  items  as  relative  prices  change  over  time,  failure  to  capture  new-  outlet  bias  where  consumers  respond  to
 relative  price  changes  by  shopping  at  different  retail  outlets,  and  inadequately  measuring  quality  changes  and  new  products  reflecting  changes  in  technology  and  consumer  demand.
 (3)  Whether  the  BLS  productivity  data  fully  reflect  changes  in  the  quality  of  goods  and  services.  Questions  persist  as  to  whether  the  total  factor  productivity  measure  for  the  United  States  economy  reflect
 the  extent  that  succeeding  generations  of  capital  equipment  are  more  productive  and  hence  whether  an  appropriate  adjustment  to  reflect  has  been  incorporated.  Note  that  this  will  increase  the  computed  level  of
 capital  stock  and  increase  the  flow  of  capital  services.
 (4)  Whether  the  best  techniques  are  used  to  introduce  new,  advanced  products  into  the  data  series.
 (5)  Whether  the  BLS  methods  capture  the  full  impact  of  new  information  technology  on  economic  performance.  It  has  been  suggested,  for  example,  that  failure  to  adequately  reflect  information
 technology  understates  TFPUS.  39
 These  issues  are  discussed  fully  in  a  series  of  articles  in  the  February  1998  issue  of  the  Monthly  Labor  Review.
 One  other  source  of  bias  not  previously  noted  is  also  present.  This  involves  composition  changes  in  inputs.  In  the  case  of  labor  composition,  changes  include  increased  educational  attainment  over  time
 which  increases  TFPUS  and  an  increased  share  of  teenagers  and  females  in  the  labor  force  which  reduces  TFPUS.  40  In  the  case  of  capital,  there  has  been  continuous  substitution  of  equipment  for  structures  and  of
 short-  lived  equipment  like  computers  for  long-  lived  equipment  like  furniture.  Failure  to  reflect  this  substitution  underestimates  the  capital  stock  component  of  the  TFPUS  measure.
 C.  Biases  in  the  Measurement  of  IPUS
 The  general  input  price  measure  used  is  the  Bureau  of  Labor  Statistics  Nonfarm  Business  Sector  Price  Index.  The  sources  of  the  data  used  in  constructing  this  measure  are  the  same  as  those  for  the  BLS
 measure  of  TFPUS.  Consequently,  the  major  issues  related  to  the  BLS  measure  of  TFPUS  are  applicable  to  the  measurement  of  IPUS.  41  These  include  the  question  of  how  to  define  output  in  service-  producing
 industries,  the  biases  present  in  constructing  the  Consumer  Price  Index,  the  issue  of  the  introduction  of  new,  improved  factors  of  production,  and  the  effect  of  quality  changes  in  goods  and  services  used  in
 production.
 39  Dale  W.  Jorgenson  and  Kevin  J.  Stiroh,  Information  Technology  and  Growth,  89  Am.  Econ.  Rev.  109-15
 (1999).
 40  Robert  J.  Gordon,  U.  S.  Economic  Growth  Since  1870:  One  Big  Wave?,  89  Am.  Econ.  Rev.  123-  28
 (1999).
 41  Lucy  P.  Eldridge,  How  Price  Indexes  Affect  BLS  Productivity  Measures,  122  Monthly  Lab.  Rev.  35-  46
 (1999).
30
 Federal  Communications  Commission  FCC  99-  345
 31
 While  there  are  biases  in  the  measure  of  IPUS  due  to  biases  in  its  components,  considered  together  with  any  bias  in  the  measure  of  TFPUS  attributable  to  input  prices  would  most  likely  have  an  insignificant
 net  effect  on  the  productivity  offset.  For  example,  an  increase  in  the  price  of  one  of  the  factor  inputs  will  lower  TFPUS  but  it  will  increase  the  input  price  differential  resulting  in  little  net  change  in  X.
 D.  Biases  in  the  Measurement  of  IPLEC
 The  measure  of  IPLEC  is  a  composite  index  using  the  labor  price  index,  a  materials  price  index,  and  a  cost  of  capital  index.  The  biases  introduced  were  previously  noted  in  the  context  of  measuring
 TFPLEC  including  changes  in  the  quality  of  capital  and  capacity  utilization  variations.  The  effective  price  of  labor  is  probably  overestimated  while  the  cost  of  capital  even  after  adjustment  to  reflect  competitive
 conditions  might  or  might  not  be  correct.  An  adjustment  in  the  cost  of  capital  to  reflect  changes  in  quality  would  increase  the  price  while  an  adjustment  to  reflect  changes  in  capacity  utilization  would  reduce  the
 price.
 As  noted  previously,  there  are  obvious  upward  biases  in  the  measure  of  IPLEC  due  to  biases  in  its  components.  This,  however,  considered  in  conjunction  with  the  bias  in  the  measure  of  TFPLEC
 attributable  to  these  input  prices  results  in  a  minimal  net  effect  on  the  productivity  offset  (X-  factor).  That  is,  increasing  (decreasing)  the  price  of  one  of  the  factor  inputs  will  lower  (raise)  TFPLEC  but  it  will  reduce
 (raise)  the  input  price  differential  resulting  in  little  net  change  in  X.
 IV.  Conclusion
 Based  on  the  above  analysis,  the  X-  factor  calculated  in  the  1997  Staff  TFP  Study  is  a  significantly  downward  biased  estimator  of  the  actual  rate  of  cost  reductions  achieved  by  the  price  cap
 LECs.  The  residual  value  method  employed  in  this  study  inappropriately  incorporated  the  steadily  rising  profits  of  LECs  into  increases  in  the  cost  of  the  capital  input.
 Correction  of  the  LECs'  historical  cost  of  capital  plus  the  change  in  the  local  output  measure  results  in  a  somewhat  larger  absolute  value  of  the  X-  factor  than  the  Commission  computed  in  the  1997  staff  TFP
 study.  42  Over  the  1986-  1995  period,  for  example,  we  compute  the  average  X-  factor  to  be  5.82  versus  an  average  of  5.23  from  the  1997  staff  TFP  study.  Between  1991  and  1995,  when  price  caps  were  in  effect,
 our  corrected  average  X-  factor  is  6.14  versus  an  average  of  5.22  from  the  1997  staff  TFP  study.  Also,  there  is  somewhat  more  year-  to-  year  variation  in  our  corrected  X-  factor  than  there  is  in  the  1997  staff
 TFP  study.  43  Using  data  covering  the  period  1986  to  1998,  the  updated  X-  factor  is  6.02  while  for  the  1991  to  1998  period,  the  X-  factor  is  6.33.
 42  The  recalculated  X-  factor  is  in  column  I  of  Table  B-  12  in  Appendix  B.
 43  Column  I  of  Table  B-  12  in  Appendix  B  shows  the  variance  in  the  X-  factor  series  for  our  corrected  X-factor
 and  the  X-  factor  in  the  1997  staff  TFP  study.
31
 Federal  Communications  Commission  FCC  99-  345
 32
 Appendix  B
 The  1999  Staff  TFP  Study
 Noel  D.  Uri
 Introduction
 Under  price  cap  regulation,  the  weighted  average  of  the  prices  for  the  services  in  a  given  price  cap,  or  the  actual  price  index  (API),  must  be  less  than  or  equal  to  the  price  cap  index.  An  incumbent
 LEC's  Price  Cap  Index  (PCI)  is  adjusted  annually  in  accordance  with  the  PCI  relationship  defined  in  the  Code  of  Federal  Regulations.  1  The  PCI  relationship  consists  of  a  measure  of  inflation,  in  this  case  the
 Gross  Domestic  Product  Price  Index  (GDP-  PI),  minus  the  X-  factor,  plus  or  minus  any  permitted  exogenous  cost  changes.  The  X-  factor  is  nominally  referred  to  as  the  productivity  offset.
 The  X-  factor  is  defined  to  equal  the  sum  of  the  change  in  LECs'  productivity  less  the  change  in  productivity  of  the  aggregate  economy  plus  the  change  in  input  prices  for  the  aggregate  economy  less  the
 change  in  LECs'  input  prices.  In  the  1997  Price  Cap  Review  Order,  2  a  total  factor  productivity  (TFP)  approach  was  adopted  for  estimating  LECs  change  in  productivity.
 Considerable  thought  has  gone  into  and  extensive  comments  were  made  concerning  the  selection  of  a  technique  to  calibrate  the  X-  factor.  3  This  decision  process  will  not  be  revisited.  Rather,  the
 immediate  concern  is  with  measuring  the  X-  factor  based  on  the  most  recent,  consistent,  and  comprehensive  data  generally  and  publicly  available.
 Background
 The  methodology  used  by  the  FCC's  staff  to  estimate  LEC  Total  Factor  Productivity  (TFP)  and  the  input  prices,  and  to  calculate  the  LEC  TFP  and  input  price  differentials  used  in  the  FCC's  LEC
 X-  factor  for  interstate  access  is  discussed  here.  TFP  is  calculated  based  on  the  LECs  regulated  books  of  account  excluding  miscellaneous  services.  Thus,  the  measure  of  total  factor  productivity  is  based  on  the
 productivity  of  all  LEC  activities  including  local  service,  intrastate  toll/  access  service,  and  interstate  service.  The  calculations  are  for  the  period  1985  through  1998.  4
 1  Section  61.  45  (b)  of  the  Commission's  rules,  47  C.  F.  R.    61.  45(  b).
 2  Price  Cap  Performance  Review  for  Local  Exchange  Carriers,  Fourth  Report  and  Order  in  CC  Docket
 No.  94-  1  and  Second  Report  and  Order  in  CC  Docket  No.  96-  262,  12  FCC  Rcd  16642,  16645  (1997)  ("  1997  Price  Cap  Review  Order").
 3  Much  of  this  is  recounted  in  the  1997  Price  Cap  Review  Order.
 4  The  X-  factor  actually  relies  on  changes  in  TFP.  The  discussion,  however,  is  in  terms  of  TFP  levels  from
 which  changes  are  derived.
32
 33
 Federal  Communications  Commission  FCC  99-  345
 The  calculations  are  based  on  the  Fisher  Ideal  Index,  a  standard  and  economically  justifiable  measure.  The  TFP  estimates  embody  what  is  believed  to  be  the  best  approach  available  for  measuring  the
 X-  factor  and  emulates  the  approach  used  in  1997  Price  Cap  Review  Order.
 The  study  is  based  on  data  publicly  available  from  the  Federal  Communications  Commission,  the  Bureau  of  Economic  Analysis  of  the  U.  S.  Department  of  Commerce,  and  the  Bureau  of  Labor  Statistics  of
 the  U.  S.  Department  of  Labor.  Consistent  with  the  1997  Price  Cap  Review  Order,  the  data  are  for  just  the  Regional  Bell  Operating  Companies  (RBOCs).
 Methodological  Issues
 A  productivity  index  is  generally  defined  as  an  output  index  divided  by  an  input  index.  5  An  important  question  is  which  functional  form  for  the  index  number  should  be  used.  Here,  known
 functional  forms  for  index  numbers  are  related  to  functional  forms  for  the  underlying  aggregator  function.
 Two  important  examples  of  a  quantity  index  are  the  Laspeyres  and  Paasche  index.  The  Laspeyres  quantity  index,  QL,  is  defined  as
 (1)  Q  L  (p  0  ,  p  1  ,  x  0  ,  x  1  )  =  p  0  x  1  /  p  0  x  0
 where  p  t  >  0  is  a  vector  of  prices  in  period  t  =  0,  1  and  x  >  0  is  the  corresponding  vector  of  quantities.  The  Paasche  quantity  index,  QP,  is  defined  as
 (2)  Q  P  (p  0  ,  p  1  ,  x  0  ,  x  1  )  =  p  1  x  1  /  p  1  x  0  .
 Fisher  6  suggested  that  the  Ideal  Index  is  given  as  the  geometric  mean  of  QL  and  QP
 (3)  Q  F  (p  0  ,  p  1  ,  x  0  ,  x  1  )  =  ((  p  0  x  1  /  p  0  x  0  )  (p  1  x  1  /  p  1  x  0  ))  1/  2  .
 Let  f(  x)  define  an  aggregator  function  and  suppose  that  x  t  >  0  is  the  solution  to
 (4)  maxx  {f(  x):  p  t  x    p  t  x  t  }  t=  0,  1
 where  f(  x)  =  (x'Ax)  1/  2  and  A  =  [aij]  is  a  symmetric  matrix  of  coefficients.  Konus  7  then  shows  that
 (5)  f(  x  1  )  /  f(  x  0  )  =  Q  F  (p  0  ,  p  1  ,  x  0  ,  x  1  ).
 5  The  theory  of  total  factor  productivity  and  the  requisite  use  of  productivity  indexes  in  measuring
 productivity  change  is  fully  developed  in  Dale  W.  Jorgenson  and  Zvi  Griliches,  The  Explanation  of  Productivity  Change,  34  Rev.  Econ.  Stud.  249-  83  (1967).
 6  Irving  Fisher,  The  Making  of  Index  Numbers  (1922).
 7  Alexander  A.  Konus,  The  Problem  of  the  True  Cost  of  Living,  7  Econometrica  10-  29  (1939).
33
 34
 Federal  Communications  Commission  FCC  99-  345
 If  a  quantity  index  Q  F  (p  0  ,  p  1  ,  x  0  ,  x  1  )  and  a  functional  form  aggregator  function  f  satisfy  (5),  then  the  quantity  index  Q  F  is  said  to  be  exact  for  the  aggregator  function.  Konus  shows  that  the  Laspeyres
 quantity  index  is  exact  for  a  fixed  aggregator  function  while  the  Paasche  quantity  index  is  exact  for  a  linear  aggregator  function.  Afriat,  8  Diewert,  9  Pollack,  10  and  Samuelson  and  Swamy  11  provide  other
 examples  of  exact  index  numbers.  Among  exact  index  numbers,  however,  the  Fisher  quantity  index  corresponds  to  a  functional  form  for  f  that  can  provide  a  second  order  approximation  to  an  arbitrary
 twice-  differentiable  linearly  homogeneous  function.  Thus,  the  use  of  the  Fisher  Ideal  Index  is  economically  justified.  12
 The  input  and  output  quantity  indices  are  constructed  using  the  Fisher  Ideal  Index.  As  noted,  this  index  is  the  geometric  average  of  the  Laspeyres  Index  and  the  Paasche  Index.  This  index  is  desirable
 because  it  is  calculated  using  the  weights  of  adjacent  years.  During  periods  of  relatively  substantial  and  significant  changes  in  prices,  a  significant  bias  can  appear  in  fixed  weight  measures,  even  during  periods
 close  to  the  base  period.  13
 Expanding  beyond  just  two  periods,  a  chained  Fisher  Ideal  Quantity  Index  can  be  constructed  between  periods  0  and  t.  It  is  the  product  of  each  of  the  Fisher  Ideal  Quantity  Indexes  between  periods  0
 and  t.  All  input  and  output  quantity  indexes  are  chained  Fisher  Ideal  Quantity  Indexes.  The  chained  Fisher  Ideal  Quantity  Index  addresses  one  of  the  most  fundamental  problems  in  measuring  output  -  the
 choice  of  the  base  period  with  which  all  other  periods  are  compared.  Since  changes  in  the  Fisher  Ideal  Quantity  Index  are  calculated  using  weights  of  adjacent  years,  the  chaining  of  the  annual  changes  allows
 for  the  effect  of  changes  in  relative  prices.  Thus,  the  Fisher  Ideal  Chained  Quantity  Index  calculates  an  index  that  is  appropriate  for  each  period  and  avoids  having  to  update  a  fixed-  weight  index.  It  also  negates
 the  substitution  bias  that  is  inherent  in  a  fixed-  weight  index.  14  Finally,  the  chain-  type  index  provides  a  more  accurate  measure  of  current  period  output  during  periods  of  significant  price  changes.  15
 8  S.  N.  Afriat,  The  Theory  of  International  Comparisons  of  Real  Income  and  Prices,  International
 Comparisons  of  Prices  and  Quantities,  (David  J.  Daly  ed.  1972).
 9  W.  Erwin  Diewert,  Exact  and  Superlative  Index  Numbers,  4  J.  Econ.  115-  46  (1976).
 10  Richard  Pollack,  The  Theory  of  the  Cost  of  Living  Index,  (1971).
 11  Paul  A.  Samuelson  and  Subramanian  Swamy,  Invariant  Economic  Index  Numbers  and  Canonical
 Duality:  Survey  and  Synthesis,  64  Am.  Econ.  Rev.  566-  93  (1974).
 12  For  more  on  the  properties  of  this  index  see  W.  Erwin  Diewert,  The  Economic  Theory  of  Index
 Numbers:  A  Survey,  Essays  in  the  Theory  and  Measurement  of  Consumer  Behavior,  (Angus  Deaton  ed.  1980);  and  S.  N.  Afriat,  The  Price  Index  (1977).
 13  Robert  P.  Parker  and  Jack  E.  Triplett,  Chain-  Type  Measures  of  Real  Output  and  Prices  in  the  U.  S.
 National  Income  and  Product  Accounts:  An  Update,  Bus.  Econ.  2-  7  (Oct.  1996).
 14  Franklin  M.  Fisher  and  Karl  Shell,  Economic  Theory  of  Price  Indices  (1972).
 15  J.  Steven  Landefeld  and  Robert  P.  Parker,  BEA's  Chain  Indexes,  Time  Series,  and  Measures  of  Long-Term
 Economic  Growth,  77  Survey  of  Current  Bus.  58-  68  (1997).
34
 35
 Federal  Communications  Commission  FCC  99-  345
 Indexes  of  input  prices  are  constructed  in  a  fashion  analogous  to  that  for  the  input  and  output  quantity  indexes.  That  is,  by  calculating  a  Fisher  Ideal  Price  Index.
 The  Laspeyres  price  index,  PL,  is  defined  as
 (6)  P  L  (p  0  ,  p  1  ,  x  0  ,  x  1  )  =  p  1  x  0  /  p  0  x  0
 where  p  t  >  0  is  a  vector  of  prices  in  period  t  =  0,1  and  x  >  0  is  the  corresponding  vector  of  quantities.  The  Paasche  price  index,  PP,  is  defined  as
 (7)  P  P  (p  0  ,  p  1  ,  x  0  ,  x  1  )  =  p  1  x  1  /  p  0  x  1  .
 The  Fisher  Ideal  Index  for  prices  is  given  as  the  geometric  mean  of  PL  and  PP
 (8)  P  F  (p  0  ,  p  1  ,  x  0  ,  x  1  )  =  ((  p  1  x  0  /  p  0  x  0  )  (p  1  x  1  /  p0  x  1  ))  1/  2  .
 A  chained  Fisher  Ideal  Price  Index  can  be  constructed  between  periods  0  and  t.  It  is  the  product  of  each  of  the  Fisher  Ideal  Price  Indexes  between  periods  0  and  t.  All  input  price  indexes  are  chained
 Fisher  Ideal  Price  Indexes.  As  is  the  case  for  output  and  input  indexes,  a  chained  price  index  is  superior  to  a  fixed-  weight  index.
 Aggregating  across  different  types  of  outputs  to  construct  the  Fisher  Ideal  Quantity  Index  for  output  in  a  given  period  is  accomplished  by  using  the  relevant  commodity  share  of  total  revenue
 corresponding  the  type  of  output.  Aggregating  across  the  different  factors  of  production  to  construct  the  input  quantity  and  input  price  indexes  in  a  given  period  is  accomplished  by  using  the  relevant  shares  of
 total  payments  to  the  corresponding  factors.
 Calculation  of  Output  Quantity  Indexes
 (a)  Data  Sources
 The  output  index  is  based  on  actual  quantity  measures  available  from  the  Commission.  Basic  local  service  revenue,  end  user  revenue,  switched  access  revenue,  special  access  revenue,  state  access
 revenue,  and  total  long  distance  network  revenue  are  taken  from  the  Commission's  Statistics  of  Communications  Common  Carriers  for  1985  through  1998.  Also  taken  from  this  source  are  data  on  the
 number  of  special  access  lines,  the  number  of  business  access  lines,  residential  access  lines,  and  public  access  lines.  Local  access  volume  is  measured  by  the  number  of  local  dial  equipment  minutes  as  are  state
 toll  and  intrastate  access  volumes  by  dial  equipment  minutes.  These  data  are  taken  from  the  FCC  Monitoring  Reports.  They  are  directly  accessible  via  the  FCC  web  site.  16  Interstate  switched  access
 minutes  are  from  the  same  Monitoring  Reports.  The  component  data  for  interstate  revenue  are  given  in  are  given  in  Table  B-  1.  Total  revenue  data  for  each  type  of  service  are  given  in  Table  B-  2.
 (b)  Output  Category  Quantity  Indices  and  Revenue  Shares
 16  http://  www.  fcc.  gov
35
 36
 Federal  Communications  Commission  FCC  99-  345
 The  initial  step  in  the  process  is  to  construct  an  interstate  quantity  index  to  measure  growth  of  interstate  services.  This  index  is  constructed  using  the  physical  measures  of  three  services  including  the
 number  of  access  lines,  the  number  of  interstate  switched  access  minutes,  and  the  number  interstate  special  access  lines.  The  number  of  access  lines  is  measured  by  the  sum  of  the  number  of  business,
 public,  and  residential  access  lines.
 A  service's  share  of  total  interstate  revenue  is  used  to  weigh  each  service  in  the  construction  of  the  measure  of  interstate  output.  That  is,  the  number  of  access  lines  is  weighted  by  the  End  User
 Common  Line  revenue  share  of  total  interstate  revenues.  The  number  of  switched  access  minutes  is  weighted  by  the  switched  access  revenue  share,  and  the  number  of  special  access  lines  is  weighted  by  the
 special  access  revenue  share.  A  Fisher  Ideal  Quantity  Index  is  then  constructed.  The  composite  Fisher  Ideal  Interstate  Quantity  (Output)  Index  is  derived  by  chaining  the  Fisher  Interstate  Ideal  Output  Index.
 The  resulting  Fisher  Ideal  Chained  Output  Index  is  given  in  Table  B-  3.
 A  comparable  procedure  is  used  to  construct  revenue  shares  and  quantity  indices  for  total  local  service  and  state  toll/  access  service.  State  toll/  access  revenues  are  total  toll  service  revenues  plus
 intrastate  access  revenues.  The  physical  units  associated  with  total  local  service  are  the  number  of  dial  equipment  minutes  for  local  calls  while  for  state  toll/  access  service,  the  physical  units  are  intrastate  dial
 equipment  minutes.  These  data  are  taken  from  the  FCC  Monitoring  Reports.  17
 (c)  Total  Output  Index
 The  total  LEC  output  index  is  computed  using  the  quantity  indexes  for  local  service,  intrastate  toll/  access  service,  and  interstate  service  and  their  respective  revenue  shares.  The  interstate  share  of  total
 revenue  is  calculated  using  the  sum  of  end  user  revenue,  switched  access  revenue  (formerly  called  "carrier's  carrier  facilities  revenues"),  and  interstate  special  access  revenue.  A  Fisher  Ideal  Quantity
 (Output)  Index  is  constructed  by  aggregating  these  measures  for  each  year.  The  composite  Fisher  Ideal  Output  Index  is  derived  by  chaining  the  Fisher  Ideal  Output  Index.  The  resulting  Fisher  Ideal  Chained
 Output  Index  for  total  LEC  output  is  given  in  Table  B-  4.  Note  that  the  percentage  changes  (growth  rate)  are  calculated  as  natural  logarithmic  (loge)  changes.
 Calculation  of  Input  Quantity  Indexes
 (a)  Labor
 The  measure  of  the  quantity  labor  is  based  on  annual  accounting  data  for  the  number  of  employees  from  the  Commission's  Statistics  of  Communications  Common  Carriers.  These  data  are
 reported  in  Table  B-  5.  Since  there  is  no  objective  way  to  account  for  the  contribution  of  part-  time  versus
 17  Data  for  local  DEMs  and  intrastate  DEMs  for  1998  are  not  yet  available.  They  are  forecast  using  simple
 exponential  extrapolations.  Because  local  DEMs  exhibit  an  identifiable  structural  shift  beginning  in  1992  associated  with  increased  Internet  access,  data  for  1992  to  1997  only  are  fit  to  a  time  trend  and  then  forecast.  After  correction
 for  the  ubiquitous  first  order  serial  correlation  ever-  present  in  these  sorts  of  relationships,  the  resulting  coefficient  of  determination  is  0.  97.  Data  for  years  prior  to  1992  were  not  considered  because  the  adjustments  necessary  in  the
 extrapolation  specification  would  negate  any  benefits  associated  with  the  added  degrees  of  freedom.  For  intrastate  DEMs,  there  was  no  structural  shift  in  the  functional  relationship  so  data  for  the  entire  1985  to  1997  period  was
 used.  The  resulting  coefficient  of  determination  is  0.99  after  correction  for  first  order  serial  correlation.
36
 37
 Federal  Communications  Commission  FCC  99-  345
 full-  time  employees,  just  the  total  number  of  employees  is  used  as  the  labor  input  measure.  This,  however,  does  not  introduce  a  substantial  bias  in  the  labor  quantity  measure  since  part-  time  employees
 accounted  for  less  that  0.7  percent  of  the  workforce  in  1998.
 (b)  Capital
 (i)  Perpetual  Inventory  Method
 The  starting  point  for  construction  of  a  quantity  index  of  capital  input  is  the  measurement  of  the  capital  stock.  A  perpetual  inventory  method  is  employed  to  estimate  the  level  of  capital  stock.  18  In
 discrete  time,  the  method  is
 (9)  Kt  =  It  +  (1  -  )  Kt-  1
 where  Kt  is  the  end-  of-  period  capital  stock,  It  is  the  quantity  of  investment  occurring  in  the  period,  and    is  the  rate  of  replacement  (depreciation).  The  data  requirements  for  implementation  of  this  perpetual
 inventory  method  are  investment  in  constant  (inflation-  adjusted)  prices,  a  capital  benchmark,  and  a  rate  of  replacement.
 The  perpetual  inventory  method  is  used  to  remove  embedded  inflation  that  would  distort  the  measurement  of  capital.  Consistent  with  the  1997  Price  Cap  Review  Order,  only  one  asset  class  is
 considered  because  the  record  shows  that  the  number  of  asset  classes  does  not  significantly  impact  the  measured  change  in  TFP.  The  application  of  the  perpetual  inventory  model  relies  on  Commission
 depreciation  rates.
 The  book  value  of  plant  is  used  as  the  basis  for  calculating  the  benchmark  (i.  e.  initial  level)  capital  stock.  In  order  to  calculate  constant  dollar  investment,  chained  Fisher  asset  prices  from  the  Bureau
 of  Economic  Analysis  of  the  U.  S.  Department  of  Commerce  are  used  deflate  capital  additions.
 The  benchmark  capital  stock  is  based  on  the  end  of  year  1985  book  value.  Because  of  the  1988  capital/  expense  shift,  it  is  necessary  to  adjust  both  end  of  year  1985  total  plant  in  service  less  accumulated
 depreciation  and  1985-  1987  capital  additions.  The  capital/  expense  shift  factor  used  in  the  1997  Price  Cap  Review  Order  is  employed  here  to  reduce  capital  additions  for  1985  through  1987.  Adjusted  capital
 additions  for  1985,  1986,  and  1987  are  just  the  product  of  the  unadjusted  capital  additions  and  the  adjustment  factor  of  0.888.  Unadjusted  capital  addition  data  were  obtained  from  FCC  Form  M.
 (ii)  Asset  Price
 With  just  a  single  asset  class,  a  single  composite  asset  price  index  is  needed.  First,  Bureau  of  Economic  Analysis  asset  prices  were  obtained  from  the  National  Income  and  Product  Accounts.  These
 included  prices  for  three  asset  categories  including  Communications  Equipment  (NIPA  19  Table  7.8:
 18  Raymond  W.  Goldsmith,  A  Perpetual  Inventory  of  National  Wealth,  Studies  in  Income  and  Wealth,
 (1951).
 19  National  Income  and  Product  Accounts  complied  by  the  Bureau  of  Economic  Analysis  of  the  U.  S.
 Department  of  Commerce.
37
 38
 Federal  Communications  Commission  FCC  99-  345
 Chained-  Type  Price  indexes  for  Private  Purchases  of  Producers'  Durable  Equipment  by  Type,  Line  7),  Telecommunication  Structures  (NIPA  Table  7.7:  Chained-  Type  Price  Indexes  for  Private  Purchases  of
 Structure  by  Type,  Line  12),  and  a  composite  asset  price  for  Producer  Durables  (NIPA  Table  7.1,  Line  39).  Capital  additions  data  are  then  grouped  into  categories  corresponding  to  the  NIPA  asset  categories,
 and  each  category's  share  calculated.  (The  capital/  expense  shift  adjustment  factor  noted  previously  has  no  effect  on  the  shares  because  it  is  multiplicative  and  applies  equally  to  all  asset  categories.)
 From  these  data,  a  Fisher  Ideal  Price  Index  is  computed  and  used  to  form  a  chained  Fisher  Ideal  Price  Index  for  the  single  asset.  This  price  index  is  used  to  deflate  adjusted  capital  additions  in  the
 perpetual  inventory  model.
 (iii)  Benchmark  Capital  Stock
 The  benchmark  capital  stock  is  derived  using  the  FCC  accounting  relationship
 (10)  TPIS.  BOYt  +  CAt  -  Retirest  =  TPIS.  EOYt
 where  TPIS.  BOYt  denotes  beginning  of  the  year  total  plant-  in-  service  for  period  t,  CAt  denotes  capital  additions  in  period  t,  Retirest  denotes  plant  retirements  in  period  t,  and  TPIS.  EOYt  denotes  total  plant-  in-service
 at  the  end  of  the  year  for  period  t.  All  of  these  data  are  taken  from  the  FCC  Form  M.
 Adjusted  capital  additions  are  incorporated  which  results  in  revised  values  for  TPIS.  EOYt  for  1985,  1986,  and  1987.  The  benchmark  capital  stock  is  then  obtained  by  subtracting  accumulated
 depreciation  from  adjusted  TPIS.  BOY1985.
 As  is  standard  practice  in  most  TFP  studies,  20  land  is  not  included  as  a  capital  stock  component  when  forming  the  benchmark  capital  stock.
 (iv)  Depreciation  Rate
 A  time-  invariant  depreciation  rate  for  the  single  asset  class  is  computed  as  an  arithmetic  average  of  annual  depreciation  rates.  The  depreciation  rate  for  period  t  is  given  as
 (11)  t  =  (DEPR.  ACRLSt)  /  ((  TPIS.  BOYt  +  TPIS.  EOYt)/  2).
 where  DEPR.  ACRLSt  denotes  depreciation  accruals.  The  data  are  taken  from  FCC  Form  M.
 The  value  of    is  the  average  (mean)  value  of  t  over  the  period  1985-  1998.
 A  summary  of  capital  adjustments  and  average  depreciation  is  given  in  Table  B-  6.
 (v)  Capital  Input  Quantity  Index
 20  Land  is  typically  omitted  from  consideration  in  TFP  studies  with  the  exception  of  those  dealing  with
 agriculture.  This  is  more  fully  explored  in  V.  Eldon  Ball  et  al.,  Agricultural  Productivity  Revisited,  79  Am.  J.  Agric.  Econ.  1045-  63  (1997).
38
 39
 Federal  Communications  Commission  FCC  99-  345
 The  capital  input  quantity  index  series  is  computed  by  dividing  current  period  capital  stock  by  the  base  period  capital  stock.  These  data  are  reported  in  Table  B-  7.
 (c)  Materials  -  Part  I
 The  materials  quantity  is  computed  as  materials  expense  divided  by  a  materials  price  index.  Materials  expense  is  a  residual.  It  is  the  difference  between  total  operating  expense  and  the  sum  of  labor
 compensation  and  depreciation  and  amortization  expense.  21
 Until  now  computation  of  the  various  components  of  the  X-  factor  have  been  straightforward  and  mechanistic.  Things  are  somewhat  more  complicated,  however,  from  this  point  forward.  To  explain  the
 complications  and  what  is  necessary  to  compute  materials  quantity,  a  digression  is  in  order.
 (d)  Digression
 TFP  models  in  general  measure  productivity  as  the  ratio  of  an  index  of  outputs  of  a  firm  to  an  index  of  its  inputs  over  a  given  time  period  (e.  g.,  a  year).  The  growth  in  productivity  is  the  amount  by
 which  this  ratio  changes  over  time.  In  making  these  calculations,  it  is  critical  that  real  changes  in  productivity  be  separated  from  the  effects  of  changes  in  input  prices.
 It  is  typically  the  case  that  three  inputs  are  considered  in  TFP-  type  studies.  These  inputs  consist  of  labor,  capital,  and  materials.  22  Sometimes  a  fourth  input  energy  is  considered.  This  is  not  done
 here.  When  just  three  inputs  are  used  in  the  analysis,  materials  is  considered  as  a  residual.  That  is,  it  accounts  for  whatever  input  expenditures  are  not  attributable  to  labor  and  capital.
 The  growth  rate  of  the  index  of  inputs  is  determined  by  the  growth  rates  of  the  labor,  capital,  and  materials  input  indices  weighted  by  their  relative  contribution  to  total  input  cost.  The  growth  rate  of
 capital  is  a  complex  procedure,  requiring  a  determination  of  capital  stock  and  the  flow  of  capital  services  from  capital  stock.
 A  number  of  very  explicit  assumptions  underlie  TFP  analyses.  In  particular,  the  conventional  method  of  measuring  TFP  of  firms  (which  is  used  in  the  1997  Price  Cap  Review  Order)  is  to  assume  that
 there  are  constant  returns  to  scale  and  that  observed  inputs  and  outputs  have  been  generated  by  firms  in  competitive,  long  run  equilibrium.  With  prices  of  output  and  inputs  fixed,  the  firm  chooses  input  levels
 21  Materials  expenses  for  1985  through  1987  must  be  adjusted  for  two  accounting  changes  that  became
 effective  in  1988.  First,  beginning  in  1988  all  expenses  from  nonregulated  services  that  had  joint  and  common  costs  with  regulated  services  were  reported  in  operating  expenses.  Second,  certain  plant  investments  that  formerly  were
 capitalized  began  to  be  expensed  in  the  year  they  were  incurred.  Accordingly  expenses  for  1985  through  1987  were  adjusted  upward  to  put  them  on  a  basis  comparable  to  the  accounting  expense  recorded  from  1988  onward.  The
 adjustment  factor  is  computed  by  dividing  the  sum  of  annual  reported  operating  expense  plus  the  additional  materials  expense  resulting  from  both  the  regulated/  nonregulated  change  and  the  capital/  expense  shift  by  reported
 operating  expenses  for  the  years  1985-  1987.  These  percentages  are  used  to  adjust  1985  through  1987  operating  expenses  of  the  LECs.
 22  Dale  W.  Jorgenson  et  al.,  Productivity  and  U.  S.  Economic  Growth  (1987).
39
 40
 Federal  Communications  Commission  FCC  99-  345
 so  as  to  maximize  profit.  23  The  measure  of  TFP  growth  obtained  by  conventional  means  is  not,  however,  appropriate  whenever  firms  are  not  in  a  long  run  cost  minimizing  equilibrium.  A  firm  is  not  in  long  run
 equilibrium  whenever  the  firm's  input-  output  bundle  is  other  than  corresponding  to  a  point  on  the  long  run  unit  cost  curve.  If  the  firm  is  not  in  long  run  equilibrium,  then  profit  is  not  zero.  24
 Before  exploring  the  implications  of  this  observation  for  the  results  reported  in  the  1997  Price  Cap  Review  Order,  it  is  necessary  to  examine  what  price  caps  are  and  to  assess  the  mechanics  of
 estimating  an  historical  productivity  offset.
 (i)  Price  Caps  in  Theory
 Overview
 Assume  that  there  are  two  periods,  t=  1,2.  Suppose  that  in  each  period  the  firm  produces  units  of  a  single  output,  qt,  using  a  single  input  which  will  be  called  labor  and  denoted  by  Lt.  25  Let  wt  denote  the
 price  of  labor  in  period  t  and  pt  denote  the  price  of  output  in  period  t.  An  outcome  for  the  market  in  period  t  is  defined  to  be  a  vector  of  these  four  variables,  (pt,  qt,  wt,  Lt).  If  the  output  price  of  the  firm  is
 regulated  so  that  its  revenues  equal  its  costs,  then  the  outcome  in  each  period  will  satisfy
 (12)  pt  =  wt  Lt  /qt  .
 Define  the  variable  zt  to  be  the  productivity  of  the  firm  in  period  t  measured  in  units  of  output  per  units  of  input.  Thus,
 (13)  zt  =  qt  /wt  .
 Substitution  of  relationship  (13)  into  relationship  (12)  yields
 (14)  pt  =  wt  /zt  .
 That  is,  in  a  regulated  market  where  the  firm  is  constrained  to  earn  zero  economic  profit,  the  output  price  will  be  equal  to  the  input  price  divided  by  productivity.
 Use  the  following  notation  to  denote  the  percentage  change  in  each  variable  between  periods  1  and  2:
 (15)  %  p  =  (p2  -  p1)/  p1
 23  See,  e.  g.,  Ernst  R.  Berndt  and  Melvyn  A.  Fuss,  Productivity  Measurement  with  Adjustments  for
 Variations  in  Capacity  Utilization  and  Other  Forms  of  Temporary  Equilibrium,  33  J.  Econ.  7-  29  (1986);  and  Dale  W.  Jorgenson  and  Zvi  Griliches,  The  Explanation  of  Productivity  Change,  34  Rev.  Econ.  Stud.,  Vol.  249-  83  (1967).
 24  Michael  A.  Crew  and  Paul  R.  Kleindorfer,  Incentive  Regulation  in  the  United  Kingdom  and  the  United
 States:  Some  Lessons,  9  J.  Reg.  Econ.  211-  25  (1996).
 25  Nothing  changes  if  both  output  and  input  are  viewed  as  consisting  of  baskets  of  goods.  Inputs  and
 outputs  are  considered  here  as  single  entities  to  simplify  the  exposition.
40
 41
 Federal  Communications  Commission  FCC  99-  345
 (16)  %  q  =  (q2  -  q1)/  q1
 (17)  %  pw  =  (w2  -  w1)/  w1
 (18)  %  L  =  (L2  -  L1)/  L1
 (19)  %  z  =  (z2  -  z1)/  z1
 It  follows  immediately  from  equation  (14)  that  when  outcomes  in  both  periods  are  regulated  so  that  the  firm  earns  zero  economic  profit,  then
 (20)  %  p  =  %  w  -  %  z.
 That  is,  if  the  firm  is  constrained  to  earn  zero  economic  profit,  then  the  percentage  change  in  output  price  will  just  equal  the  percentage  change  in  input  price  minus  the  percentage  change  in
 productivity.
 Price  Caps  With  an  Exogenous  Input  Price  Index
 The  well-  understood  problem  with  cost-  based  regulation  is  that  the  regulated  firm  has  very  little  incentive  to  be  efficient  because  any  efficiency  gains  are  immediately  captured  by  the  regulator.  Price
 caps  are  meant  to  ameliorate  this  problem.  The  basic  idea  is  very  simple.  Suppose  that  period  1  has  just  ended  and  the  regulator  is  considering  how  to  set  price  in  period  2.  The  regulator  knows  that  if  he  or  she
 uses  cost-  based  regulation  to  set  price  in  period  2  that  the  resulting  price  will  satisfy  relationship  (9).  The  essential  idea  of  price  caps  is  to  replace  the  term  %  z  with  an  estimate  of  %  z  made  in  period  1.  Let  E
 denote  the  estimate  of  productivity  change.  At  the  end  of  period  1,  it  is  announced  that  the  price  in  period  2  will  be  set  according  to  the  formula
 (21)  %  p  =  %  w  -  E.
 That  is,  the  regulator  will  wait  until  the  end  of  period  1  and  observe  the  actual  change  in  input  prices  and  allow  output  prices  to  increase  by  this  percentage.  Rather  than  wait  to  observe  actual  changes
 in  productivity,  however,  the  output  prices  are  adjusted  by  a  fixed  amount  regardless  of  the  firm's  realized  productivity  change.
 The  firm  will  then  earn  a  normal  profit  (and  zero  economic  profit)  if  the  regulator  is  able  to  correctly  guess  the  actual  (realized)  productivity  change.  The  firm  will  have  a  strong  incentive,  however,
 to  improve  productivity  because  it  will  keep  any  positive  or  negative  profits  that  result  if  its  actual  productivity  improvement  is  different  than  the  predicted  productivity  change.
 One  could  also  imagine  the  regulator  replacing  %  w  with  an  exogenous,  pre-  specified  estimate.  Then  the  regulator  would  simply  tell  the  regulated  firm  that  its  output  prices  would  change  by  a  certain
 percent  regardless  of  the  level  of  actual  input  price  inflation  in  period  2.  This  practice  is  not  usually  followed,  however,  because  the  regulated  firm  typically  purchases  inputs  in  relatively  competitive
 markets  so  that  the  regulated  firm  has  very  little  influence  over  the  price  it  pays  for  inputs.  Therefore,  exogenously  pre-  specifying  a  target  percentage  change  for  input  prices  would  have  no  desirable  incentive
41
 42
 Federal  Communications  Commission  FCC  99-  345
 effects.  It  would  increase  the  risk,  however,  that  the  regulated  firm  is  required  to  incur  to  the  extent  that  future  input  prices  vary  unpredictably.  Therefore,  %  w  is  not  typically  replaced  by  a  pre-  specified
 estimate.
 Price  Caps  With  An  Exogenous  National  Output  Price  Index
 Price  cap  schemes  generally  have  the  form  that  output  price  is  allowed  to  increase  in  a  given  year  by  the  amount  that  some  price  index  actually  increases  minus  some  pre-  specified  amount.  The  foregoing
 section  suggests  that  a  very  simple,  transparent,  and  straightforward  method  for  implementing  a  price  cap  system  would  be  to  base  the  price  index  on  INPUT  prices  for  the  industry  being  regulated.  This  practice,
 however,  is  not  typically  followed.  Rather,  instead  of  basing  the  price  index  on  INPUT  prices  for  the  industry  being  regulated,  regulators  generally  use  a  composite  price  index  for  OUTPUT  prices  for  the
 economy  as  a  whole.  In  particular,  this  is  the  practice  followed  by  the  Federal  Communications  Commission  (hereafter  Commission)  to  regulate  interstate  access  prices.
 When  a  national  output  index  is  substituted  for  an  industry  input  index,  a  correction  has  to  be  made  for  the  fact  that  input  prices  in  the  particular  industry  being  regulated  may  be  systematically
 growing  at  a  different  rate  than  output  prices  in  the  economy  as  a  whole.  For  example,  because  of  rapid  technological  advances  in  telecommunications,  input  prices  for  telecommunications  firms  are  not
 changing  at  the  same  rate  as  output  prices  in  the  economy.  Consequently,  the  regulator  must  choose  an  adjustment  factor  to  correct  for  this  difference.  Let  D  denote  the  regulator's  estimate  of  the  rate  at  which
 output  prices  in  the  economy  as  a  whole  change  differently  than  input  prices  in  the  regulated  industry.  Let  RPI  denote  the  percentage  change  in  the  national  output  price  index.  The  price  cap  formula  becomes
 (22)  %  p  =  RPI  -  D  -  E  .
 This  can  be  rewritten  as
 (23)  %  p  =  RPI  -  X
 where
 (24)  X  =  D  +  E.
 This  is  the  familiar  form  of  a  price  cap  plan.  That  is,  the  X-  factor  is  composed  of  two  separate  components.  It  is  the  sum  of  the  predicted  productivity  growth  of  the  regulated  firm,  E,  plus  the  expected
 amount  that  national  output  prices  grow  faster  than  industry  input  prices,  D.
 Choosing  the  X-  Factor
 The  efficiency  incentives  created  by  a  price  cap  scheme  are  not  affected  by  the  size  of  the  X-factor  that  the  regulator  chooses.  The  simple  fact  that  the  X-  factor  is  fixed  and  independent  of  the  actual
 costs  incurred  creates  an  incentive  for  the  firm  to  be  efficient.  The  regulator  is  still  concerned  with  the  level  of  the  X-  factor,  however,  because  this  affects  the  distribution  of  the  economic  surplus  between  the
 firm  and  consumers.  It  can  also  potentially  affect  whether  or  not  the  regulated  firm  chooses  to  exit  the  industry.  If  the  X-  factor  is  chosen  too  high,  the  regulated  firm  may  well  choose  to  exit  the  industry.  On
 the  other  hand,  if  it  is  chosen  too  low,  the  regulated  firm  will  earn  positive  economic  profit  and  consumers  will  pay  higher  prices  than  necessary.  Therefore,  the  regulator  has  a  considerable  interest  in  choosing  an
42
 43
 Federal  Communications  Commission  FCC  99-  345
 X-  factor  so  that  it  will  be  above  but  as  close  as  possible  to  the  sum  of  the  expected  value  of  the  firm's  productivity  change  and  the  difference  between  the  industry's  input  price  change  and  the  economy's
 output  price  change.
 One  relevant  piece  of  information  is  the  behavior  of  these  variables  in  the  recent  past.  26  Let  EH  denote  the  historical  rate  of  productivity  growth  for  the  regulated  firm  over  the  recent  past.  Let  DH  denote
 the  historical  difference  between  the  rate  of  change  in  output  prices  for  the  economy  as  a  whole  and  the  rate  of  change  of  input  prices  for  the  regulated  industry.  Let  XH  denote  the  sum  of  these  two  variables.
 That  is,
 (25)  XH  =  DH  +  EH.
 The  variable  XH  will  be  referred  to  as  the  historically  justified  X-  factor.  The  typical  practice  of  regulators  is  to  calculate  the  historically  justified  X-  factor  and  then  to  set  the  X-  factor  equal  to  this  unless
 factors  can  be  identified  which  will  cause  the  future  values  to  depart  systematically  from  the  historical  values.  If  so,  some  attempt  must  be  made  to  adjust  exogenously  for  such  factors.
 These  identifiable  factors  are  customarily  most  important  when  price  caps  are  being  first  introduced  to  replace  rate-  of-  return  regulation.  In  such  a  circumstance,  it  is  generally  argued  that  the
 increased  efficiency  incentives  created  by  the  switch  to  price  caps  will  result  in  higher  future  rates  of  productivity  growth  than  were  historically  observed.  Therefore,  it  is  argued  that  future  productivity
 growth  is  likely  to  be  higher  than  past  productivity  growth  for  some  period  of  time.  27  Therefore,  when  price  caps  are  first  introduced,  regulators  often  set  the  X-  factor  somewhat  higher  than  the  historically
 justified  rate  in  anticipation  of  increased  production  efficiency.  The  Commission  followed  this  practice  when  it  first  introduced  price  caps  for  LECs  in  1991.  The  actual  X-  factor  was  set  0.5  percent  above  the
 historically  justified  level  and  this  difference  was  nominally  referred  to  as  the  consumer  productivity  dividend.
 Note,  however,  that  increased  efficiency  incentives  created  by  the  switch  to  price  caps  will  dissipate  when  price  caps  have  been  in  effect  for  some  time  and  the  historical  period  being  evaluated  is
 one  where  price  caps  were  in  place.  28  In  this  case,  the  historical  data  are  already  reflecting  the  increased  incentives  for  efficiency  created  by  price  caps.
 In  theory  it  is  possible  to  imagine  all  sorts  of  reasons  why  future  rates  of  productivity  growth  may  diverge  from  past  rates,  even  if  price  caps  have  been  in  place  for  some  time.  29  For  example,  one  of  the
 26  David  E.  M.  Sappington,  Strategic  Firm  Behavior  under  a  Dynamic  Regulatory  Adjustment  Process,  11
 Bell  J.  Econ.  360-  72  (1980).
 27  In  fact  if  this  were  not  true,  there  would  be  no  reason  to  implement  price  caps  in  the  first  place.
 28  David  P.  Baron,  Information,  Incentives,  and  Commitment  in  Regulatory  Mechanisms:  Regulatory
 Innovation  in  Telecommunications,  6  Price  Caps  and  Incentive  Regulation  in  Telecommunications  (Michael  A.  Einhorn  ed.  1991).
 29  A  number  of  these  reasons  are  explored  in,  e.  g.,  Ferenc  Kiss,  Productivity  Gains  in  Bell  Canada,  in
 Economic  Analysis  of  Telecommunications:  Theory  and  Applications  (Leon  Courville  et  al.  eds.  1983);  and  Donald  (continued  .  .  .)
43
 44
 Federal  Communications  Commission  FCC  99-  345
 main  sources  of  measured  productivity  growth  is  simply  growth  in  demand,  since  production  technologies  of  regulated  firms  frequently  exhibit  economies  of  scale.  Therefore,  if  the  estimated  rate  of  demand
 growth  in  the  future  is  different  than  the  historical  rate  of  demand  growth,  this  would  create  a  basis  for  predicting  a  difference  between  historical  and  future  rates  of  productivity  growth.
 In  practice,  however,  regulators'  information  is  often  much  too  unreliable  to  attempt  to  make  such  corrections.  Consequently,  in  many  regulated  industries  it  may  be  that  the  only  course  of  action  on  the
 part  of  the  regulator  than  can  withstand  a  critical  challenge  is  for  the  regulator  to  set  the  future  X-  factor  equal  to  the  historical  rate.
 There  is  some  evidence  that  the  Commission  is  in  fact  in  this  position.  In  the  1997  Price  Cap  Review  Order,  the  Commission  calculated  that  the  historically  justified  X-  factor  was  approximately  5.2
 percent  but  then  attempted  to  argue  that  the  future  X-  factor  should  be  set  at  6.0  percent.  The  U.  S.  Court  of  Appeals  for  the  D.  C.  Circuit  recently  remanded  this  decision  to  the  Commission,  stating  that  the
 Commission  had  not  adequately  justified  the  additional  amount  to  the  historically  justified  rate.
 (i)  Price  Caps  in  Theory  and  Practice
 The  Commission's  description  of  its  methodology  for  calculating  the  historically  justified  X-factor  in  the  1997  Price  Cap  Review  Order  appears  to  be  different  than  the  procedure  for  estimating  the
 DH  and  EH  described  above.  This  difference,  however,  is  only  superficial.  The  procedure  used  by  the  Commission  to  estimate  XH  is,  in  fact,  precisely  as  described  above.  This  is  explained  in  what  follows.
 In  the  description  of  its  procedure  in  the  1997  Price  Cap  Review  Order,  the  Commission  states  that  it  calculates  the  historically  justified  X-  factor  according  to  the  following  formula:
 (26)  X(  H)  =  (%    TFPLEC(  H)  -  %  TFPUS(  H))  +  (%    IPUS(  H)  -  %  IPLEC(  H))
 where  X(  H)  denotes  the  historical  X-  factor,  %  TFPLEC(  H)  denotes  the  percent  change  in  the  historical  total  factor  productivity  of  local  exchange  carriers  between  period  t-  1  and  t,  30  %  TFPUS(  H)  denotes  the
 percent  change  in  the  historical  total  factor  productivity  for  the  entire  U.  S.  economy  between  period  t-  1  and  t,  %  IPUS  denotes  the  percent  change  in  the  historical  input  prices  of  all  goods  and  services  used  to
 produce  output  of  goods  and  services  in  the  United  States  between  period  t-  1  and  t,  and  %  IPLEC  denotes  the  percent  change  in  the  historical  input  prices  of  local  exchange  carriers  used  to  produce  local  service,
 intrastate  toll/  access  service,  and  interstate  service  between  period  t-  1  and  t.  31
 J.  Kridel  et  al.,  The  Effects  of  Incentive  Regulation  in  the  Telecommunications  Industry:  A  Survey,  9  J.  Reg.  Econ.  269-  306  (1996).
 30  Note  that  the  time  period  subscripts  are  suppressed  in  order  to  facilitate  the  exposition.
 31  The  basic  principle  underlying  price  cap  regulation  and  the  need  for  a  X-  factor  together  with  relevant
 literature  citations  are  fully  presented  in  Jeffrey  I.  Bernstein  and  David  E.  M.  Sappington,  Setting  the  X-  Factor  in  Price  Cap  Regulation  Plans,  Working  Paper  6622,  National  Bureau  of  Economic  Research,  Cambridge,  MA,  June
 1998.
44
 45
 Federal  Communications  Commission  FCC  99-  345
 On  the  surface,  relationship  (26)  does  not  appear  to  be  the  same  as  equation  (25)  which  the  previous  analysis  suggests  is  what  is  used  to  calculate  the  historically  justified  X-  factor.  Equation  (26)
 can  be  rewritten,  however,  as
 (27)  X(  H)  =  {%    TFPLEC(  H)}  +  {-  %  TFPUS(  H))  +  %  IPUS(  H)  -  %  IPLEC(  H)}  .
 The  term  in  the  first  set  of  brackets  in  equation  (27)  corresponds  to  the  variable  EH  in  equation  (25).  Therefore,  equations  (27)  and  (25)  are  in  fact  equivalent  if  it  can  be  shown  that  the  terms  in  the
 second  set  of  bracket  of  relationship  (27)  correspond  to  DH.  This  equivalence  is  demonstrated  in  what  follows.  Let  RPI(  H)  denote  the  rate  of  change  in  output  prices  in  the  economy  as  a  whole  over  the
 historical  period.  Then,  it  is  always  true  that
 (28)  RPI(  H)  =  -  %  TFPUS(  H))  +  %  IPUS(  H).
 That  is,  because  the  economy  in  aggregate  is  nearly  competitive,  the  percentage  change  in  output  prices  is  just  equal  to  the  percentage  change  in  input  prices  minus  the  percentage  change  in  productivity.
 Substitute  relationship  (28)  into  the  second  bracketed  term  of  relationship  (27).  Rearranging  terms  gives
 (29)  RPI(  H)  -  %  IPLEC(  H)
 This  is  the  historical  difference  between  the  rate  of  change  of  prices  for  aggregate  output  and  industry  input,  which  is,  by  definition,  DH.
 (iii)  The  Use  the  Residual  Value  Method  for  Determining  Capital  Prices
 The  above  discussion  shows  that  the  Commission  in  the  1997  Price  Cap  Review  Order  implemented  price  caps  and  calculated  an  historically  justified  X-  factor  equal  to  the  sum  of  DH  and  EH
 where  the  formulas  for  estimating  DH  and  EH  are  given  by
 (30)  DH  =  RPI(  H)  -  %  IPLEC(  H)
 (31)  EH  =  %  TFPLEC(  H).
 This  being  the  case,  it  is  possible  to  explain  the  error  that  the  Commission  made  in  the  1997  Price  Cap  Review  Order  in  the  calculation  of  the  historically  justified  X-  factor.
 The  1997  Staff  TFP  Study  associated  with  the  1997  Price  Cap  Review  Order  made  a  conceptual  error  in  using  actual  imputed  cost  of  capital  when  measuring  the  productivity  of  regulated  companies.
 The  problem  arises  because  of  the  use  of  the  residual  value  approach  for  determining  the  cost  of  the  capital  input.  With  this  approach,  the  Commission  in  the  1997  Price  Cap  Review  Order  first  directly
 determined  the  price  and  quantity  used  of  every  input  (i.  e.,  labor  and  materials)  except  capital.  That  is,  it  directly  calculated  the  realized  return  to  every  non-  capital  input.  Next,  based  on  an  estimate  of  the  capital
 stock,  the  assumption  that  all  revenue  is  distributed  to  the  inputs,  and  given  the  returns  to  labor  and  materials  based  on  historical  data,  a  cost  of  capital  is  imputed.
 Conceptually,  the  difference  (residual)  between  revenue  and  the  required  returns  to  all  non-  capital  inputs  (which  is  just  the  nominal  amount  used  to  impute  a  cost  of  capital)  consists  of  two  parts.  The  first
45
 46
 Federal  Communications  Commission  FCC  99-  345
 part  is  the  required  return  to  capital.  The  second  part  is  the  excess  profit  earned  by  the  firm.  Instead  of  attempting  to  separate  this  difference  into  two  parts,  however,  the  Commission  in  the  1997  Price  Cap
 Review  Order  simply  assumed  that  all  of  this  residual  was  the  required  return  to  capital,  i.  e.,  that  no  excess  profit  was  earned.  This  is  a  reasonable  assumption  for  a  competitive  market,  and  even  for  non-competitive
 markets,  as  long  as  the  goal  of  the  study  is  simply  to  measure  the  productivity  gains  revealed  by  market  forces.  32  In  a  regulatory  setting,  however,  the  productivity  gains  are  "revealed"  by  the
 application  of  the  X-  factor,  not  by  market  forces.
 By  attributing  all  of  the  residual  to  the  capital  inputs,  the  residual  value  method  tends  automatically  to  define  whatever  profits  or  losses  the  LECs  realized  during  the  historical  period  as
 increases  or  decreases  in  the  cost  of  capital  inputs.  Suppose,  for  example,  that  the  Commission  chose  too  low  an  X-  factor  during  the  historical  period  being  considered,  causing  the  LECs'  profits  to  increase.
 Under  the  residual  value  method,  the  Commission  would  conclude  that  the  historical  cost  of  LEC  capital  inputs  rose  more  rapidly  during  this  period  than  it  actually  did.  The  Commission  then  would  predict  an
 equally  large  growth  in  LEC  capital  cost  in  the  future,  and  thus  calculate  an  X-  factor  that  was  still  too  low.  33  Consequently,  LECs'  profits  would  continue  to  increase  despite  no  increase  in  LEC  productivity.
 On  the  other  hand,  suppose  that  the  Commission  chose  too  high  an  X-  factor  during  the  historical  period,  causing  LECs'  profits  to  decrease.  Under  the  residual  value  method,  the  Commission  would  conclude  that
 the  historical  cost  of  LEC  capital  inputs  fell  more  rapidly  during  this  period  than  it  actually  did.  The  Commission  then  would  predict  an  equally  large  price  reduction  for  capital  in  the  future,  and  thus
 calculate  an  X-  factor  that  was  still  too  high.  Consequently,  LECs'  profits  would  continue  to  decrease  despite  no  decrease  in  LEC  productivity.  In  either  scenario,  the  LECs'  productivity  remains  constant.
 Only  their  rate  of  return  is  affected  by  the  incorrect  X-  factor.  Thus,  the  residual  value  method  produces  an  X-  factor  that  is  biased  in  the  same  direction  as  whatever  bias  existed  in  the  historical  period.
 To  be  useful  to  regulators,  then,  any  X-  factor  study  of  a  regulated  industry  must  augment  or  reduce  the  actual  amounts  of  capital  compensation  in  such  a  way  as  to  duplicate  the  forces  of  a
 competitive  market.  Merely  replacing  the  residual  capital  value  method  of  determining  the  capital  compensation  rate  with  an  independent  price  index  would  not  be  sufficient.  It  would  merely  cause
 counterbalancing  shifts  between  the  input  price  differential  and  the  productivity  growth  rate  differential.  To  capture  the  gains  in  productivity  that  would  have  been  revealed  in  a  competitive  market,  total  capital
 compensation  must  vary  with  the  cost  of  capital  one  would  observe  in  a  competitive  market.
 In  order  to  correct  the  miscalculation  of  the  LECs'  cost  of  capital  in  the  1997  Staff  TFP  study,  it  is  necessary  to  replace  the  TFP  study's  cost  of  capital  with  a  competitive  cost  for  the  inputs  during  the
 historical  years.  Next,  it  is  necessary  to  adopt  a  surrogate  to  emulate  a  competitive  cost  of  capital  for  LECs  because  LECs  have  never  operated  in  a  competitive  market.  An  independent  price  series  is
 employed  to  compute  the  annual  change  in  the  cost  of  capital  for  a  competitive  market.  34  Specifically,
 32  Dale  W.  Jorgenson  and  Zvi  Griliches,  The  Explanation  of  Productivity  Change,  34  Rev.  Econ.  Stud.
 249-  83  (1967).
 33  One  component  of  the  X-  factor  calculation  is  the  difference  between  the  US  Economy's  average  input
 costs  and  the  historical  input  costs  of  LECs.  Thus,  an  artificially  high  LEC  capital  cost  will  lead  to  an  artificially  low  X-  factor.
 34  Following  standard  financial  economics  conventions,  the  absolute  magnitude  of  the  change  in  the
 independent  price  series  is  used  in  deference  to  the  relative  change.  USTA,  in  its  originally  proposed  method  for  (continued  .  .  .)
46
 47
 Federal  Communications  Commission  FCC  99-  345
 Moody's  Baa  corporate  bond  rate  reported  in  the  1999  Economic  Report  of  the  President  (Table  B-  73)  is  used  to  calculate  the  adjustment.  35  These  data  are  reproduced  in  Table  B-  8.  Combining  the  base  year  36
 imputed  cost  of  capital  from  the  1997  staff  TFP  study  with  the  change  in  the  competitive  cost  of  capital  gives  an  independent  competitive  cost  of  capital  for  LECs  in  each  year  of  the  historical  period.  This
 competitive  cost  of  LECs'  capital  input  is  used  in  conjunction  with  an  adjusted  cost  of  labor  (see  below)  and  materials  inputs  from  the  1997  staff  TFP  study,  as  well  as  the  percent  change  in  the  U.  S.  nonfarm
 business  sector  input  price  growth,  to  compute  the  corrected  input  price  differential  portion  of  the  historical  X-  factor.
 Recalculating  the  LECs'  historical  cost  of  capital  changes  the  level  of  the  LECs'  revenues,  taxes,  and  operating  expenses  for  the  historical  years.  If  the  difference  between  the  estimate  of  the  competitive
 cost  of  LECs'  capital  inputs  and  the  imputed  cost  from  the  1997  staff  TFP  study  is  computed,  an  estimate  of  the  excess  profits  realized  by  LECs  for  each  year  of  the  historical  period  is  obtained.  37  Reducing  the
 LECs'  total  revenue  by  this  amount  results  in  a  revenue  stream  that  emulates  what  LECs  would  have  realized  in  a  competitive  market.  A  reduction  in  revenue  implies  a  reduction  in  taxes,  38  which  in  turn
 reduces  total  operating  expense.  39  It  is  this  reduced  total  operating  expense  that  is  used  in  the  computation  of  the  materials  input  quantity.
 Reducing  LEC  revenues  to  what  would  have  been  realized  in  a  competitive  market  also  changes  the  LECs'  TFP  portion  of  the  X-  factor.  The  new  revenue  level  changes  the  LECs'  input  growth  rate  by
 altering  the  relative  share  of  revenue  accounted  for  by  each  input  40  -  labor,  materials,  and  capital.  41  In
 computing  the  cost  of  capital,  uses  a  proportionate  change.  See,  e.  g.,  Letter  from  Mary  McDermott,  Vice  President    Legal  &  Regulatory  Affairs,  USTA,  to  William  F.  Caton,  Acting  Secretary,  FCC,  Jan.  20,  1995,  Attachment  at  11.
 35  Any  index  for  a  competitively  determined  cost  of  capital  should  be  acceptable  because  changes  in  the
 cost  of  capital  in  competitive  markets  is  similar  across  markets.  The  use  of  a  different  series  would  yield  comparable  results  given  the  competitive  nature  of  financial  markets.  For  example,  the  correlation  over  the  period
 1985-  1998  between  Moody's  Aaa  corporate  bond  rate  and  the  Baa  rate  used  is  0.  99.  Analogously,  the  correlation  between  the  10-  year  U.  S.  Treasury  securities  rate  and  the  30-  year  U.  S.  Treasury  securities  rate  and  Moody's  Baa  rate
 over  the  same  period  is  0.99  and  0.98,  respectively.  In  terms  of  changes  in  the  absolute  level  of  the  series,  the  correlation  between  Moody's  Baa  corporate  bond  rate  and  Moody's  Aaa  corporate  bond  rate,  the  10-  year  U.  S.
 Treasury  securities  rate,  and  the  30-  year  U.  S.  Treasury  securities  rate  over  the  period  1985-  1998  is  0.  99,  0.  98,  and  0.97,  respectively.
 36  The  base  year  is  1991.  This  is  the  first  full  year  of  LEC  price  cap.  The  implicit  assumption  is  that  the
 cost  of  capital  for  this  year  was  at  a  competitive  level.  That  is,  it  is  assumed  that  LECs  earned  a  normal  return  in  that  year.
 37  The  LECs'  excess  profits  are  due  to  their  output  prices  falling  slower  than  their  cost  of  capital  during  the
 historical  years.  This  situation  would  not  have  occurred  in  a  competitive  market.
 38  Following  standard  Commission  procedures,  it  is  assumed  that  taxes  are  39  percent  (34  percent  federal
 and  5  percent  state).
 39  Taxes  are  one  component  of  operating  expenses.
 40  Note  that  in  using  shares  to  aggregate  inputs,  the  1997  staff  TFP  study  introduced  another  source  of  bias.
 Namely,  the  observed  shares  were  not  cost  minimizing  shares  (i.  e.,  the  factors  are  not  paid  the  value  of  their  marginal  products  as  assumed  in  the  TFP  approach).  The  correction  makes  an  adjustment  for  this  bias.
47
 48
 Federal  Communications  Commission  FCC  99-  345
 other  words,  the  LECs'  input  growth  rate  changes  in  response  to  the  changes  in  the  relative  weight  of  each  input  factor.  42  Combining  the  output  growth  rate  from  the  1997  staff  TFP  study  with  the  revised  LECs'
 input  growth  rate  yields  the  corrected  TFP  growth  rate  for  the  LECs.
 (e)  Materials  -  Part  II
 As  noted,  an  adjustment  to  the  cost  of  capital  changes  the  effective  total  operating  expense  due  to  a  change  in  taxes.  The  adjusted  total  operating  expense  less  labor  compensation  less  depreciation  and
 amortization  divided  by  the  materials  price  index  gives  materials  input  quantity.  The  materials  price  index  is  the  same  as  that  used  in  the  1997  Price  Cap  Review  Order.  43  The  materials  input  quantity  series
 is  found  in  Table  B-  9.
 (f)  Total  Input  Quantity  Index
 Having  constructed  input  quantity  indexes  for  each  of  the  factors  of  production,  a  composite  input  index  can  be  computed.  Using  relative  shares  of  payments  to  each  of  the  factors  as  weights,  an  aggregate
 input  value  for  each  year  is  calculated.  These  values  are  used  to  compute  a  Fisher  Ideal  Index  for  input  quantity.
 To  compute  the  relative  shares,  payments  to  each  of  the  factors  is  needed.  The  payment  to  labor  is  adjusted  total  compensation,  the  payment  to  materials  is  adjusted  materials  expense,  and  the  payment  to
 capital  is  adjusted  property  income  with  depreciation.  Adjusted  property  income  is  capital  stock  quantity  in  period  t-  1  times  the  imputed  competitive  cost  of  capital  for  period  t.  Adjustments  to  material  payments
 and  property  income  (capital  compensation)  have  been  previously  discussed.  Adjustments  to  labor  compensation  are  deferred  to  a  subsequent  section.  Payments  to  the  factors  of  production  together  with
 factor  shares  are  given  in  Table  B-  10.
 The  composite  Fisher  Ideal  Input  Quantity  Index  is  derived  by  chaining  the  Fisher  Ideal  Input  Quantity  Index.  The  resulting  Fisher  Ideal  Chained  Input  Quantity  Index  is  given  in  Table  B-  11.  Note
 that  the  percentage  changes  (growth  rate)  are  calculated  as  natural  logarithmic  (loge)  changes.
 Total  Factor  Productivity  for  LECs  and  the  TFP  Differential
 The  percentage  change  in  total  factor  productivity  is  the  measure  for  the  productivity  component  of  the  X-  factor.  This  is  calculated  as  the  percentage  change  in  total  output  (Table  B-  4)  less  the  percentage
 41  The  recalculation  does  not  change  the  labor  and  capital  input  quantity  indexes.  The  materials  input
 index,  however,  (computed  as  the  total  operating  expenses  minus  labor  compensation,  depreciation,  and  amortization),  changes  when  the  operating  expenses  are  reduced.
 42  The  change  in  relative  weights  means  that  the  weights  used  in  computing  the  LECs'  input  price  growth
 must  be  recomputed  which,  in  turn,  implies  a  recomputation  of  LECs'  excess  profits,  etc.  This  is  an  iterative  process.
 43  The  price  index  is  based  on  those  categories  of  expenditures  from  the  National  Input-  Output  Tables
 compiled  by  the  Bureau  of  Economic  Analysis  of  the  U.  S.  Department  of  Commerce  that  focus  on  materials  purchases  by  communications  industries.  The  materials  price  index  is  a  Tornquist  index.
48
 49
 Federal  Communications  Commission  FCC  99-  345
 change  in  input  quantity  (Table  B-  11).  For  both  output  and  input  quantity,  the  Fisher  Ideal  Chained  Index  is  used.  The  percentage  changes  (growth  rate)  are  calculated  as  natural  logarithmic  (loge)  changes.
 Annual  changes  together  with  the  historical  averages  for  various  periods  is  given  in  Table  B-  10.
 The  productivity  component  of  the  X-  factor  as  specified  in  relationship  (26)  consists  of  the  difference  between  LECs  TFP  growth  rate  and  the  TFP  growth  rate  of  the  aggregate  economy.  This
 differential  is  presented  in  Table  B-  12.  The  Bureau  of  Labor  Statistics  of  the  U.  S.  Department  of  Labor  estimate  of  Private  Nonfarm  Business  Sector  Multifactor  Productivity  is  used  to  compute  the  TFP  growth
 rate  for  the  aggregate  economy.  44,  45  The  1998  value  of  this  multifactor  productivity  series  is  not  currently  available.  It  is  forecast  by  estimating  a  structural  relationship  between  output  per  hours  of  all  persons
 employed  and  private  nonfarm  business  multifactor  productivity  using  a  double  logarithmic  (loge)  transformation.  Data  for  output  per  hour  of  all  persons  employed  for  1998  is  available  from  the  Bureau  of
 Labor  Statistics  46  and  is  used  to  generate  the  forecast.  47
 The  results  indicate  that  total  factor  productivity  of  LECs  grew  about  4.2  percent  faster  than  productivity  in  the  nonfarm  private  business  sector  of  the  economy  over  the  1986  to  1998  period.
 Calculation  of  Input  Price  Indexes
 The  second  component  of  the  X-  factor  is  the  input  price  differential.  This  is  just  the  value  in  the  second  set  of  parentheses  in  equation  (26),  %  IPUS(  H)  -  %  IPLEC(  H).  Focus  for  now  on  the  changes  in
 LEC  input  prices.  The  price  of  each  factor  of  production  will  be  considered  separately.
 (a)  Labor
 Total  labor  compensation  divided  by  the  number  of  employees  gives  a  simple  way  of  computing  the  average  annual  price  of  labor.  The  resulting  series,  however,  is  not  homogeneous  over  the  1985-  1998
 period  and  hence  it  introduces  measurement  error  into  the  analysis.  Between  1985  and  1998,  the  price  of  labor,  defined  as  the  average  compensation  per  employee,  48  increased  in  real  terms  at  a  3.6  percent  annual
 44  The  multifactor  productivity  series  is  revised  from  that  used  in  the  1997  Price  Cap  Review  Order.  After
 decades  of  research  and  constructive  advocacy  by  Jorgenson  (Dale  W.  Jorgenson,  Productivity  and  Economic  Growth,  in  Fifty  Years  of  Economic  Measurement:  The  Jubilee  of  the  Conference  on  Research  in  Income  and
 Wealth  (Ernst  R.  Berndt  and  Jack  E.  Triplett  eds.  1990)),  the  Bureau  of  Labor  Statistics  of  the  U.  S.  Department  of  Labor  in  1994  adopted  the  Jorgenson  framework  for  composition  adjustment  for  all  of  its  publications  on  multifactor
 productivity  growth  over  the  period  since  1948.
 45  The  annual  series  is  from  Table  2:  Private  Nonfarm  Business:  Productivity  and  Related  Indexes,  1948-
 97.  It  is  available  via  the  Bureau  of  Labor  Statistics  Internet  site  at  http://  www.  bls.  gov.
 46  It  is  available  from  the  same  Bureau  of  Labor  Statistics  site  as  the  multifactor  productivity  series.
 47  The  coefficient  of  determination  is  0.  88.  It  is  necessary  to  correct  for  first  order  serial  correlation.  Also,
 regression  diagnostics  indicated  that  the  multifactor  productivity  datum  for  1991  is  an  outlier.  To  correct  for  this,  the  specification  includes  a  dummy  variable  for  this  year.
 48  The  average  compensation  per  employee  is  equal  to  total  labor  compensation  divided  by  the  number  of
 employees.
49
 50
 Federal  Communications  Commission  FCC  99-  345
 rate.  In  terms  of  total  compensation,  the  amount  paid  for  labor  was  approximately  the  same  in  1985  as  it  was  in  1998  even  though  the  number  of  workers  in  the  aggregate  had  been  reduced  by  over  30  percent.
 The  reason  for  this,  at  least  in  part,  is  that,  coincident  with  the  adoption  of  price  cap  plans,  labor  force  reductions  were  accomplished  by  offering  employees  monetary  incentives  to  leave  the  company  (i.  e.,
 buyouts).  There  is  some  variability  in  the  applicable  accounting  rules,  49  but  these  payments  were  generally  accrued  as  one-  time  charges  against  current  earnings.  50,  51
 To  have  a  labor  price  series  meaningful  for  TFP  analysis,  it  is  necessary  to  adjust  for  the  impact  of  the  exogenous  changes  in  labor  compensation  and  accounting  rules.  This  is  accomplished  by  adjusting
 the  labor  compensation  series  to  net  out  one-  time  charges  for  such  things  as  buyouts  and  accounting  rule  changes.  Sufficiently  detailed  information  to  allow  for  such  an  adjustment  to  the  total  compensation
 series  is  not  available  from  Statistics  of  Communication  Common  Carriers,  the  source  of  the  total  labor  compensation  and  number  of  employees  data  used  in  the  1997  Price  Cap  Review  Order.  Alternate  data
 must  be  relied  upon.  These  data  are  discussed  below.
 From  the  FCCs'  ARMIS  Report  43-  02,  total  compensation  for  the  year  is  defined  to  equal  payroll,  including  salaries,  wages,  and  payroll  related  benefits.  Separate  items  from  the  same  report  include
 salaries  and  wages  and  benefits.  Salaries  and  wages  are  defined  to  equal  salaries,  wages,  commissions,  bonuses,  incentive  awards,  and  termination  payments.  Benefits  include  pensions,  saving  plan
 contributions,  worker's  compensation,  life  and  health  insurance,  social  security  and  other  payroll  taxes.  These  data  series  are  reported  in  Table  B-  5.  52  Benefits  are  equal  to  approximately  20  percent  of  the  sum
 of  salaries  plus  wages  plus  benefits  for  the  years  1988-  1990.  Subsequently,  they  increase  annually,  reaching  a  maximum  of  30  percent  in  1994  and  then  decline  to  approximately  21  percent  in  1998.  The
 increase  in  the  proportion  of  benefits  above  20  percent  is  assumed  to  be  the  amount  attributed  to  buyouts,  accounting  rule  changes,  and  so  on.  This  amount  is  nominally  referred  to  as  excess  benefits.  This  is  the
 amount  that  must  be  netted  out  to  give  a  labor  compensation  series  that  can  be  used  in  the  TFP  analysis.
 Using  this  rule,  excess  benefits  are  computed  with  the  resulting  amount  subtracted  from  total  compensation  to  give  the  adjusted  labor  compensation  series  in  Table  B-  5.  53  The  values  in  this  series
 divided  by  the  number  of  workers  gives  an  adjusted  labor  price.  The  adjusted  labor  price  index  is  then  computed  (Table  B-  5).
 49  See,  e.  g.,  Financial  Accounting  Standards  Board  Rule  (FASB)  Number  106.
 50  Donald  J.  Kridel  et  al.,  The  Effects  of  Incentive  Regulation  in  the  Telecommunications  Industry:  A
 Survey,  9  J.  Reg.  Econ.  269-  306  (1996).
 51  The  cost  of  labor  input  (management  and  non-  management)  in  the  1997  Price  Cap  Review  Order  is
 equal  to  wages  and  salaries  expenses  plus  benefits  expenses.  This  suggests  that  the  lump-  sum  incentive  payments  would  be  recorded  as  labor  costs.  A  key  issue  is  a  measurement  problem  since  accounting  data  do  not  reflect  the
 real  cost  accurately.  To  the  extent  that  direct  observations  on  labor  input  (i.  e.,  actual  hours  worked)  are  used,  however,  any  disparities  between  accounting  costs  and  real  costs  could  be  avoided.  Unfortunately,  labor  input  is  not
 measured  by  the  number  of  hours  worked  but  as  the  total  number  of  employees.
 52  The  data  series  for  ARMIS  salaries  and  wages  and  benefits  are  incomplete  prior  to  1988  due  to  reporting
 changes  and  hence  not  used.  The  requisite  adjustments  would  be  ad  hoc  and  introduce  further  measurement  error  into  the  analysis.
 53  With  the  adjustment  in  labor  compensation  comes  an  adjustment  in  total  operating  expenses.
50
 51
 Federal  Communications  Commission  FCC  99-  345
 (b)  Capital
 As  noted  previously,  in  order  to  correct  the  miscalculation  of  the  LECs'  cost  of  capital  in  the  1997  Staff  TFP  study,  it  is  necessary  to  replace  the  TFP  study's  cost  of  capital  with  a  competitive  cost  for  the
 inputs  during  the  historical  years.  Next,  it  is  necessary  to  adopt  a  surrogate  to  emulate  a  competitive  cost  of  capital  for  LECs  because  LECs  have  never  operated  in  a  competitive  market.  An  independent  price
 series  is  employed  to  compute  the  annual  change  in  the  cost  of  capital  for  a  competitive  market.  Specifically,  Moody's  Baa  corporate  bond  rate  reported  in  the  1999  Economic  Report  of  the  President
 (Table  B-  73)  is  used  to  calculate  the  adjustment.  Combining  the  base  year  imputed  cost  of  capital  from  the  1997  staff  TFP  study  with  the  change  in  the  competitive  cost  of  capital  gives  an  independent
 competitive  cost  of  capital  for  LECs  in  each  year  of  the  historical  period.
 (c)  Materials
 The  materials  price  index  is  the  same  as  that  used  in  the  1997  Price  Cap  Review  Order.  The  price  index  is  based  on  those  categories  of  expenditures  from  the  National  Input-  Output  Tables  compiled  by  the
 Bureau  of  Economic  Analysis  of  the  U.  S.  Department  of  Commerce  that  focus  on  materials  purchases  by  communications  industries.  The  materials  price  index  is  a  Tornquist  index.  The  materials  price  index  is
 given  in  Table  B-  9.
 (d)  Total  Input  Price  Index
 Having  constructed  input  price  indexes  for  each  of  the  factors  of  production,  a  composite  input  index  can  be  computed.  Using  relative  shares  of  payments  to  each  of  the  factors  as  weights,  an  aggregate
 input  value  for  each  year  is  calculated.  These  values  are  used  to  compute  a  Fisher  Ideal  Index  for  input  price.
 To  compute  the  relative  shares,  payments  to  each  of  the  factors  is  needed.  The  payment  to  labor  is  adjusted  total  compensation,  the  payment  to  materials  is  adjusted  materials  expense,  and  the  payment  to
 capital  is  adjusted  property  income  with  depreciation.  Adjusted  property  income  is  capital  stock  quantity  in  period  t-  1  times  the  imputed  competitive  cost  of  capital  for  period  t.  Adjustments  to  material  payments
 and  property  income  (capital  compensation)  have  been  previously  discussed.  Adjustments  to  labor  compensation  are  deferred  to  a  subsequent  section.  Payments  to  the  factors  of  production  together  with
 factor  shares  are  given  in  Table  B-  10.
 The  composite  Fisher  Ideal  Input  Price  Index  is  derived  by  chaining  the  Fisher  Ideal  Input  Price  Index.  The  resulting  Fisher  Ideal  Chained  Input  Price  Index  is  given  in  Table  B-  13.  Note  that  the
 percentage  changes  (growth  rate)  are  calculated  as  natural  logarithmic  (loge)  changes.
 Input  Price  Differential
 The  input  price  differential,  the  second  component  of  the  X-  factor,  is  computed  as  the  percentage  change  in  input  prices  for  the  aggregate  economy  less  the  percentage  change  in  LECs'  input  prices.  The
51
 52
 Federal  Communications  Commission  FCC  99-  345
 measure  of  aggregate  input  price  change  used  is  the  Nonfarm  Business  Sector  Input  Price  Index  compiled  by  the  Bureau  of  Labor  Statistics  of  the  U.  S.  Department  of  Labor.  54
 The  input  price  differential  is  presented  in  Table  B-  12.  The  results  suggest  that  input  prices  in  the  nonfarm  private  business  sector  of  the  economy  grew  about  1.8  percent  faster  than  input  prices  for  LECs'
 over  the  1986  to  1998  period.
 The  X-  Factor
 The  computed  X-  factor  defined  by  equation  (26)  and  consisting  of  a  productivity  component  plus  an  input  price  differential  component  is  presented  in  Table  B-  12.  Averages  for  different  time  period
 intervals  are  presented.  The  average  is  in  the  range  of  5.8  to  6.3  percent.  It  is  interesting  to  note  that  the  averages  are  approximately  equal  for  these  different  time  periods.  55
 54  The  series  is  quarterly  and  is  taken  from  Table  2:  Private  Nonfarm  Business:  Productivity  and  Related
 Indexes,  1948-  97.  It  is  available  via  the  Bureau  of  Labor  Statistics  Internet  site  at  http://  www.  bls.  gov.
 55  The  mean  values  used  in  conjunction  with  their  respective  variances  and  sample  sizes  indicate  that,  in
 fact,  there  is  no  statistically  significant  difference  at  the  5  percent  level.
52
 53
 Federal  Communications  Commission  FCC  99-  345
 Table  B-  1.  LEC  Interstate  Revenue  ($)  -  1985-  1998
 ______________________________________________________________________________
 Year  End  User  Interstate  Switched  Special  Access  Total  Interstate  Revenue  Access  Revenue  Revenue
 Revenue  ______________________________________________________________________________
 1985  1499413893  10906203190  1960688644  14366305727
 1986  2400475814  10484265170  2574800716  15459541700
 1987  3090639929  9611996187  2657677439  15360313555
 1988  3604221000  9662529000  2539698000  15806448000
 1989  4398692000  9092575000  2253922000  15745189000
 1990  4679142000  8595750000  2209064000  15483956000
 1991  4828177000  8514130000  2119037000  15461344000
 1992  4963262000  8650880000  2153565000  15767707000
 1993  5244094000  8999065000  2097997000  16341156000
 1994  5589662000  9293783000  2217125000  17100570000
 1995  5770285000  9332869000  2529667000  17632821000
 1996  5930960000  9409639000  3070598000  18411197000
 1997  6268026000  8763815000  3851028000  18882869000
 1998  7928205000  7447289000  4894584000  20270078000  ______________________________________________________________________________
 Source:  Federal  Communications  Commission,  Statistics  of  Communication  Common  Carriers  [various  years]
53
 54
 Federal  Communications  Commission  FCC  99-  345
 Table  B-  2.  LEC  Revenue  ($)  by  Type  of  Service  1  -  1985-  1998
 ______________________________________________________________________________
 Year  Local  Service  Intrastate  Toll  Interstate  Total  Revenue  and  Intrastate  Service  Revenue
 Access  Revenue  Service
 Revenue  ______________________________________________________________________________
 1985  26960554164  13047095682  14366305727  54373955573
 1986  28626174049  13538946795  15459541700  57624662544
 1987  29150842991  14166723124  15360313555  58677879670
 1988  29226988000  14994975000  15806448000  60028411000
 1989  29973157000  14868219000  15745189000  60586565000
 1990  30699085000  15014729000  15483956000  61197770000
 1991  32059008000  14522276000  15461344000  62042628000
 1992  33359990000  14225181000  15767707000  63352878000
 1993  34598957000  14496831000  16341156000  65436944000
 1994  35758637000  14355983000  17100570000  67215190000
 1995  37684860000  13123225000  17632821000  68440906000
 1996  40523387000  12987476000  18411197000  71922060000
 1997  42460592000  12308613000  18882869000  73652074000
 1998  45643024000  12236469000  20270078000  78149571000  ______________________________________________________________________________
 1  This  excludes  miscellaneous  services.
 Source:  Federal  Communications  Commission,  Statistics  of  Communication  Common  Carriers  [various  years]
54
 55
 Federal
 Communications
 Commission
 FCC
 99-
 345
 Table
 B-
 3.
 Interstate
 Output
 Index
 -
 1985-  1998  ________________________________________________________________________________________________________________________________________________________________________________
 Year
 End
 User
 Interstate
 Special
 Number
 of
 Number
 of
 Number
 of
 Laspeyres
 Paasche
 Fisher
 Fisher
 Revenue
 Switched
 Access
 Access
 Switched
 Special
 Output
 Output
 Ideal
 Ideal
 Share
 Access
 Revenue
 Lines
 Access
 Access
 Index
 Index
 Output
 Chained
 Revenue
 Share
 Minutes
 Lines
 Index
 Output
 Share
 Index  ________________________________________________________________________________________________________________________________________________________________________________
 1985
 0.  10437
 0.  75915
 0.  13647
 92671959
 156853820000
 1230590
 1
 1
 1
 1
 1986
 0.  15527
 0.  67817
 0.  16655
 95333884
 157302701000
 1664101
 1.  05324
 1.  05225
 1.  05275
 1.  05275
 1987
 0.  20120
 0.  62576
 0.  17302
 98228585
 173154171000
 1764445
 1.  08309
 1.  07881
 1.  08095
 1.  13797
 1988
 0.  22802
 0.  61130
 0.  16067
 98270787
 187663836000
 2701817
 1.  14444
 1.  11496
 1.  12960
 1.  28546
 1989
 0.  27936
 0.  57748
 0.  14314
 101190050
 210406134000
 2448090
 1.  06576
 1.  05892
 1.  06233
 1.  36559
 1990
 0.  30219
 0.  55513
 0.  14266
 103857988
 231960296000
 3518005
 1.  12908
 1.  11449
 1.  12176
 1.  53188
 1991
 0.  31227
 0.  55067
 0.  13705
 107383807
 246710182000
 5151699
 1.  11181
 1.  09485
 1.  10330
 1.  69012
 1992
 0.  31477
 0.  54864
 0.  13658
 108938065
 262187655000
 6033139
 1.  06251
 1.  06025
 1.  06138
 1.  79387
 1993
 0.  32091
 0.  55069
 0.  12838
 112196681
 278173161000
 10153615
 1.  13614
 1.  10261
 1.  11925
 2.  00781
 1994
 0.  32686
 0.  54347
 0.  12965
 115264861
 298342017323
 13824365
 1.  09511
 1.  08680
 1.  09095
 2.  19042
 1995
 0.  32724
 0.  52928
 0.  14346
 119887506
 334981582000
 16107677
 1.  10126
 1.  09992
 1.  10059
 2.  41077
 1996
 0.  32213
 0.  51108
 0.  16677
 125333996
 363445050000
 20775150
 1.  10141
 1.  10070
 1.  10105
 2.  65440
 1997
 0.  33194
 0.  46411
 0.  20394
 131618657
 387587696669
 28051449
 1.  10851
 1.  10823
 1.  10837
 2.  94207
 1998
 0.  39112
 0.  36740
 0.  24146
 138481147
 407903661000
 34142101
 1.  08591
 1.  08785
 1.  08688
 3.  19768  ________________________________________________________________________________________________________________________________________________________________________________
 Source:
 Federal
 Communications
 Commission,
 Statistics
 of
 Communication
 Common
 Carriers
 [various
 years]
 and
 Federal
 Communications
 Commission,
 Monitoring
 Reports
 [various
 years]
55
 56
 Federal
 Communications
 Commission
 FCC
 99-
 345
 Table
 B-  4.
 Total
 LEC
 Output
 Index
 -
 1985-  1998  _________________________________________________________________________________________________________________________________________________________________
 Year
 Revenue
 Revenue
 Revenue
 Local
 Intrastate
 Interstate
 Laspeyres
 Paasche
 Fisher
 Fisher
 Growth
 Share
 -
 Share
 -
 Share
 -
 DEMs
 DEMs
 Fisher
 Output
 Output
 Ideal
 Ideal
 Rate
 (%)
 Local
 Intrastate
 Interstate
 (000)
 (000)
 Ideal
 Index
 Index
 Output
 Chained
 Toll
 Chained
 Index
 Output
 Output
 Index
 Index  _________________________________________________________________________________________________________________________________________________________________
 1985
 0.4958
 0.2400
 0.2642
 1380145900
 164191177
 1
 1
 1
 1
 1
 1986
 0.4968
 0.2350
 0.2683
 1396014000
 173173536
 1.05275
 1.03276
 1.03218
 1.03247
 1.03247
 3.19590
 1987
 0.4968
 0.2414
 0.2618
 1404776000
 183597411
 1.13797
 1.03908
 1.03778
 1.03843
 1.07215
 3.77145
 1988
 0.4869
 0.2498
 0.2633
 1469781200
 191904837
 1.28546
 1.06784
 1.06673
 1.06728
 1.14430
 6.51202
 1989
 0.4947
 0.2454
 0.2599
 1496826800
 207298177
 1.36559
 1.04541
 1.04429
 1.04485
 1.19562
 4.38736
 1990
 0.5016
 0.2453
 0.2530
 1514588700
 217913904
 1.53188
 1.05008
 1.04755
 1.04881
 1.25399
 4.76646
 1991
 0.5167
 0.2341
 0.2492
 1512946987
 219713721
 1.69012
 1.02751
 1.02531
 1.02641
 1.28711
 2.60724
 1992
 0.5266
 0.2245
 0.2489
 1558762543
 224278538
 1.79387
 1.03580
 1.03567
 1.03573
 1.33311
 3.51158
 1993
 0.5287
 0.2215
 0.2497
 1640600472
 227540869
 2.00781
 1.06059
 1.05960
 1.06010
 1.41324
 5.83650
 1994
 0.5320
 0.2136
 0.2544
 1719329169
 235362364
 2.19042
 1.05559
 1.05559
 1.05559
 1.49181
 5.41052
 1995
 0.5506
 0.1917
 0.2576
 1802545593
 246926539
 2.41077
 1.06183
 1.06161
 1.06172
 1.58389
 5.98968
 1996
 0.5634
 0.1806
 0.2560
 1955027929
 263719641
 2.65440
 1.08554
 1.08570
 1.08562
 1.71951
 8.21567
 1997
 0.5765
 0.1671
 0.2564
 2179309093
 273526580
 2.94207
 1.09909
 1.09937
 1.09923
 1.89015
 9.46127
 1998
 0.5841
 0.1566
 0.2594
 2275450746
 286005821
 3.19768
 1.05533
 1.05512
 1.05523
 1.99454
 5.37567  _________________________________________________________________________________________________________________________________________________________________
 Source:
 Federal
 Communications
 Commission,
 Statistics
 of
 Communication
 Common
 Carriers
 [various
 years]
 and
 Federal
 Communications
 Commission,
 Monitoring
 Reports
 [various
 years]
56
 57
 Federal
 Communications
 Commission
 FCC
 99-
 345
 Table
 B-  5.
 Price
 of
 Labor
 -
 1985-  1998  ____________________________________________________________________________________________________________________________________________________________________________________
 Year
 Labor
 Number
 of
 ARMIS
 ARMIS
 Ratio
 Excess
 Adjusted
 Labor
 Labor
 Labor
 Labor
 Labor
 Labor
 Compensa-
 Employees
 Salaries+
 Benefits
 Benefits
 Labor
 Price
 Price
 Price
 Price
 Price
 -
 Price
 -
 Tion
 ($)
 Wages
 ($  000)
 ($)
 Compensa-
 (original)
 (adjusted)
 Index
 Index
 %
 Change
 %
 Change
 ($  000)
 tion
 ($)
 ($)
 ($)
 (original)
 (adjusted)
 (original)
 (adjusted)
 A
 B
 B/(  A+
 B)  ____________________________________________________________________________________________________________________________________________________________________________________
 1985
 16991572326
 504113
 16991572326
 33705.88008
 33705.88008
 1.00000
 1.00000
 1986
 16728435454
 482698
 16728435454
 34656.11097
 34656.11097
 1.02819
 1.02819
 2.78018
 2.78018
 1987
 16978905847
 477714
 16978905847
 35541.98924
 35541.98924
 1.05447
 1.05447
 2.52407
 2.52407
 1988
 17030359791
 466827
 15033849
 3636033
 0.19475
 0
 17030359791
 36481.09426
 36481.09426
 1.08234
 1.08234
 2.60794
 2.60794
 1989
 16910850694
 461149
 14977589
 3669768
 0.19680
 0
 16910850694
 36671.12082
 36671.12082
 1.08797
 1.08797
 0.51954
 0.51954
 1990
 17586868921
 443105
 15230268
 3768099
 0.19834
 0
 17586868921
 39690.07102
 39690.07102
 1.17754
 1.17754
 7.91115
 7.91115
 1991
 17186211200
 414457
 15038534
 4537703
 0.23180
 622455600
 16563755600
 41466.81369
 39964.95559
 1.23025
 1.18570
 4.37924
 0.69019
 1992
 17160988000
 411167
 14976159
 4920448
 0.24730
 941126600
 16219861400
 41737.26977
 39448.35408
 1.23828
 1.17037
 0.65011
 -1.30106
 1993
 17956438000
 395639
 15479969
 5918883
 0.27660
 1639112600
 16317325400
 45385.91494
 41242.96493
 1.34653
 1.22361
 8.38073
 4.44882
 1994
 17154284000
 367196
 15085400
 6539928
 0.30242
 2214862400
 14939421600
 46716.96859
 40685.14254
 1.38602
 1.20706
 2.89056
 -1.36176
 1995
 16203522000
 346843
 15088974
 5677574
 0.27340
 1524264400
 14679257600
 46717.16598
 42322.48481
 1.38602
 1.25564
 0.00042
 3.94555
 1996
 18457448000
 338040
 15337179
 5140712
 0.25104
 1045133800
 17412314200
 54601.37262
 51509.62667
 1.61994
 1.52821
 15.59473
 19.64502
 1997
 17451673000
 338177
 15358125
 4395933
 0.22253
 445121400
 17006551600
 51605.14464
 50288.90670
 1.53104
 1.49199
 -5.64377
 -2.39842
 1998
 18262990000
 345317
 15302883
 4263993
 0.21792
 350617800
 17912372200
 52887.60762
 51872.25709
 1.56909
 1.53897
 2.45477
 3.09996  ____________________________________________________________________________________________________________________________________________________________________________________
 Source:
 Federal
 Communications
 Commission,
 Statistics
 of
 Communication
 Common
 Carriers
 [various
 years]
 and
 ARMIS
 Reports
 43-  02,
 Table
 1.B.
57
 58
 Federal
 Communications
 Commission
 FCC
 99-
 345
 Table
 B-  6.
 Capital
 Stock
 Adjustments
 and
 the
 Average
 Rate
 of
 Depreciation
 -
 1985-  1998
 (Dollar
 amounts
 shown
 in
 000)  _________________________________________________________________________________________________________________________________________________________________
 Year
 TPIS.
 BOY
 Capital
 TPIS.
 EOY
 Capital
 Adjustment
 Adjusted
 Adjusted
 Depreciation
 Adjusted
 Additions
 Retires
 Factor
 Capital
 TPIS.
 EOY
 Accruals
 Depreciation
 Additions
 Rate
 A
 B
 C
 D=  A+
 B-  C
 E
 F=  B*
 E
 G+  A+
 F-  D
 H
 I=  H/((
 A+  G)/
 2)  _________________________________________________________________________________________________________________________________________________________________
 1985
 138879365
 15001998
 149061793
 4819570
 0.888
 13321774
 147381569
 10241376
 7.15527
 1986
 149061793
 14842725
 159010189
 4894329
 0.888
 13180340
 157347804
 11826961
 7.71971
 1987
 159010189
 14138370
 168505114
 4643445
 0.888
 12554873
 166921617
 13311655
 8.16837
 1988
 168505114
 14284742
 175860216
 6929640
 1
 14284742
 175860216
 13134992
 7.62852
 1989
 175860216
 13283569
 182978381
 6165404
 1
 13283569
 182978381
 13420810
 7.48014
 1990
 182978381
 14476334
 187168695
 10286020
 1
 14476334
 187168695
 13439933
 7.26194
 1991
 187168695
 14527049
 192034545
 9661199
 1
 14527049
 192034545
 13200593
 6.96228
 1992
 192034545
 14611866
 196411915
 10234496
 1
 14611866
 196411915
 13337581
 6.86714
 1993
 196411915
 14860116
 203082418
 8189613
 1
 14860116
 203082418
 14032782
 7.02527
 1994
 203082418
 14717999
 209325562
 8474855
 1
 14717999
 209325562
 14863196
 7.20801
 1995
 209325562
 15374568
 217430207
 7269923
 1
 15374568
 217430207
 15358553
 7.19782
 1996
 217430207
 18026150
 227317120
 8139237
 1
 18026150
 227317120
 16252281
 7.30855
 1997
 227317120
 18253199
 236896179
 8674140
 1
 18253199
 236896179
 16667034
 7.18077
 1998
 236896179
 18553791
 248970288
 6479682
 1
 18553791
 248970288
 17154619
 7.06145
 avg
 1
 (85-  98)
 7.30180
 var  2
 (85-  98)
 0.11142  _________________________________________________________________________________________________________________________________________________________________
 1
 avg
 denotes
 the
 arithmetic
 mean
 of
 the
 series.
 2
 var
 denotes
 the
 variance
 of
 the
 series.
 Source:
 FCC
 Form
 M
58
 59
 Federal
 Communications
 Commission
 FCC
 99-
 345
 Table
 B-  7.
 Quantity
 of
 Capital
 for
 1985-  1998
 and
 the
 Imputed
 Cost
 of
 Capital
 for
 1991
 (Dollar
 amounts
 shown
 in
 000)  _____________________________________________________________________________________________________________________
 Year
 Benchmark
 Adjusted
 BEA
 Capital
 Capital
 Property
 Imputed
 Capital
 Capital
 Composite
 Stock
 Stock
 Income
 Cost
 of
 Stock
 Additions
 Asset
 Price
 Quantity
 Quantity
 /w
 Depreciation
 Capital
 Index
 Index  _____________________________________________________________________________________________________________________
 1984
 103903095
 1985
 109602959
 13321774
 1
 109602959
 1
 23445593794
 1986
 13180340
 1.01048
 114643584
 1.04599
 26792578943
 1987
 12554873
 1.02734
 118493306
 1.08111
 27701751800
 1988
 14284742
 1.03047
 123703569
 1.12865
 26866209000
 1989
 13283569
 1.07018
 127083465
 1.15949
 25845853000
 1990
 14476334
 1.08973
 131088425
 1.19603
 25584541000
 1991
 14527049
 1.10222
 134696416
 1.22895
 24641357000
 0.18798
 1992
 14611866
 1.10830
 138045138
 1.2595
 26477135000
 1993
 14860116
 1.11231
 141325020
 1.28943
 26914823000
 1994
 14717999
 1.11766
 144174285
 1.31542
 26366385000
 1995
 15374568
 1.11481
 147438176
 1.3452
 27166096000
 1996
 18026150
 1.11862
 152787122
 1.39401
 30414808000
 1997
 18253199
 1.11764
 157962763
 1.44123
 30679731000
 1998
 18553791
 1.11769
 163028757
 1.48745
 33830949286  _____________________________________________________________________________________________________________________
 Source:
 Table
 B-  6
 and
 National
 the
 Income
 and
 Product
 Accounts
 compiled
 by
 the
 Bureau
 of
 Economic
 Analysis
 of
 the
 U.  S.
 Department
 of
 Commerce
59
 60
 Federal  Communications  Commission  FCC  99-  345
 Table  B-  8.  Cost  of  Capital  -  1985-  1998
 _____________________________________________________________
 Year  Moody's  Imputed  Competitive  Baa  Corporate  Competitive  Cost  of
 Bond  Rate  (%)  Cost  of  Capital  Capital  ($)  Index
 ______________________________________________________________
 1985  12.72  0.21717  1.00000
 1986  10.39  0.19387  0.89271
 1987  10.58  0.19577  0.90146
 1988  10.83  0.19827  0.91297
 1989  10.18  0.19177  0.88304
 1990  10.36  0.19357  0.89133
 1991  9.8  0.18797  0.86554
 1992  8.98  0.17977  0.82778
 1993  7.93  0.16927  0.77944
 1994  8.62  0.17617  0.81121
 1995  8.2  0.17197  0.79187
 1996  8.05  0.17047  0.78496
 1997  7.86  0.16857  0.77621
 1998  7.22  0.16217  0.74674  _____________________________________________________________
 Source:  Moody's  Baa  Corporate  Bond  Rate  is  from  Table  B-  73  of  the  Economic  Report  of  the  President-  1999,  U.  S.  Government  Printing
 Office,  Washington,  DC,  1999.
60
 61
 Federal
 Communications
 Commission
 FCC
 99-
 345
 Table
 B-
 9.
 Materials
 Input
 Quantity
 -
 1985-  1998  _________________________________________________________________________________________________________
 Year
 Materials
 Adjusted
 Depreciation
 Adjusted
 Materials
 Materials
 Materials
 Price
 Total
 and
 Employee
 Expense
 Quantity
 Quantity
 Index
 Operating
 Amortization
 Compensation
 ($)
 Index
 Expense
 ($)
 Expense
 ($)
 ($)
 A
 B
 C
 D
 E=  B-
 C-  D
 F=  E/
 A  _________________________________________________________________________________________________________
 1985
 1.00000
 40609705224
 10024710656
 16991572326
 13593422242
 13593422242
 1
 1986
 1.03135
 40262200069
 11592001248
 16728435454
 11941763367
 11578768961
 0.85179
 1987
 1.05353
 42242744320
 13316999560
 16978905847
 11946838913
 11339818432
 0.83421
 1988
 1.08639
 45494083588
 13646937000
 17030359791
 14816786797
 13638527159
 1.00332
 1989
 1.12623
 47773003404
 13860101000
 16910850694
 17002051710
 15096429424
 1.11057
 1990
 1.17203
 49160848820
 13931515000
 17586868921
 17642464899
 15052912382
 1.10737
 1991
 1.20494
 50278593400
 13499778000
 16563755600
 20215059800
 16776818597
 1.23419
 1992
 1.23480
 48875289820
 13822882000
 16219861400
 18832546420
 15251495319
 1.12198
 1993
 1.25535
 49744107201
 13244514000
 16317325400
 20182267801
 16077004661
 1.18270
 1994
 1.29144
 53129310801
 15068058000
 14939421600
 23121831201
 17903914391
 1.31710
 1995
 1.32167
 54381863101
 15556284000
 14679257600
 24146321501
 18269554050
 1.34400
61
 62
 Federal
 Communications
 Commission
 FCC
 99-
 345
 1996
 1.36140
 54780054849
 16377242000
 17412314200
 20990498649
 15418318385
 1.13425
 1997
 1.39550
 57364316191
 16758832000
 17006551600
 23598932591
 16910736361
 1.24404
 1998
 1.43074
 58408447446
 17646242000
 17912372200
 22849833246
 15970695654
 1.17488  ________________________________________________________________________________________________________
 Source:
 Materials
 price
 index
 comes
 from
 the
 Input/
 Output
 Tables
 compiled
 by
 the
 Bureau
 of
 Economic
 Analysis
 of
 the
 U.
 S.
 Department
 of
 Commerce,
 depreciation
 and
 amortization
 expense
 data
 come
 from
 the
 Statistics
 of
 Communication
 Common
 Carriers,
 and
 the
 other
 values
 are
 derived
 as
 detailed
 in
 the
 text.
62
 63
 Federal
 Communications
 Commission
 FCC
 99-
 345
 Table
 B-  10.
 Factor
 of
 Production
 Shares
 of
 Total
 Payments
 -
 1985-  1998  _____________________________________________________________________________________________________________
 Year
 Adjusted
 Property
 Adjusted
 Adjusted
 Labor
 Capital
 Materials
 Labor
 Income
 Materials
 Total
 Share
 Share
 Share
 Compensa-
 /w
 Deprecia-
 Payment
 ($)
 Factor
 tion
 ($)
 tion
 ($)
 Payments
 ($)  _____________________________________________________________________________________________________________
 1985
 16991572326
 22565165047
 13593422242
 53150159615
 0.31969
 0.42455
 0.25576
 1986
 16728435454
 21249284636
 11941763367
 49919483458
 0.33511
 0.42567
 0.23922
 1987
 16978905847
 22444359210
 11946838913
 51370103970
 0.33052
 0.43691
 0.23256
 1988
 17030359791
 23494272047
 14816786797
 55341418635
 0.30773
 0.42453
 0.26773
 1989
 16910850694
 23723264293
 17002051710
 57636166697
 0.29341
 0.41160
 0.29499
 1990
 17586868921
 24600194384
 17642464899
 59829528203
 0.29395
 0.41117
 0.29488
 1991
 16563755600
 24641359753
 20215059800
 61420175153
 0.26968
 0.40119
 0.32913
 1992
 16219861400
 24215061717
 18832546420
 59267469536
 0.27367
 0.40857
 0.31776
 1993
 16317325400
 23367604541
 20182267801
 59867197742
 0.27256
 0.39032
 0.33712
 1994
 14939421600
 24897949618
 23121831201
 62959202419
 0.23729
 0.39546
 0.36725
 1995
 14679257600
 24794387029
 24146321501
 63619966130
 0.23073
 0.38973
 0.37954
 1996
 17412314200
 25134537868
 20990498649
 63537350717
 0.27405
 0.39559
 0.33036
 1997
 17006551600
 25756104311
 23598932591
 66361588503
 0.25627
 0.38812
 0.35561
 1998
 17912372200
 25617626841
 22849833246
 66379832287
 0.26985
 0.38592
 0.34423  _____________________________________________________________________________________________________________
 Source:
 Federal
 Communications
 Commission,
 Statistics
 of
 Communication
 Common
 Carriers
 [various
 years]
 with
 adjustments
 as
 described
 in
 the
 text.
63
 64
 Federal
 Communications
 Commission
 FCC
 99-
 345
 Table
 B-
 11.
 Total
 LEC
 Input
 Quantity
 Index
 -
 1985-
 1998  __________________________________________________________________________________________________________________________________________________
 Year
 Labor
 Capital
 Materials
 Labor
 Capital
 Materials
 Laspeyres
 Paasche
 Fisher
 Fisher
 Growth
 Share
 Share
 Share
 Quantity
 Quantity
 Quantity
 Input
 Input
 Ideal
 Ideal
 Rate
 (%)
 Index
 Index
 Quantity
 Quantity
 Input
 Chained
 Index
 Index
 Quantity
 Input
 Index
 Quantity  Index  __________________________________________________________________________________________________________________________________________________
 1985
 0.31969
 0.42455
 0.25576
 504113
 1
 1
 1
 1
 1
 1
 1986
 0.33511
 0.42567
 0.23922
 482698
 1.04599
 0.85179
 0.96804
 0.96360
 0.96582
 0.96582
 -3.  47804
 1987
 0.33052
 0.43691
 0.23256
 477714
 1.08111
 0.83421
 1.00590
 1.00588
 1.00589
 0.97150
 0.58715
 1988
 0.30773
 0.42453
 0.26773
 466827
 1.12865
 1.00332
 1.05882
 1.05913
 1.05898
 1.02880
 5.73029
 1989
 0.29341
 0.41160
 0.29499
 461149
 1.15949
 1.11057
 1.03648
 1.03715
 1.03681
 1.06668
 3.61531
 1990
 0.29395
 0.41117
 0.29488
 443105
 1.19603
 1.10737
 1.00064
 0.99974
 1.00019
 1.06688
 0.01899
 1991
 0.26968
 0.40119
 0.32913
 414457
 1.22895
 1.23419
 1.02608
 1.02662
 1.02635
 1.09499
 2.60077
 1992
 0.27367
 0.40857
 0.31776
 411167
 1.25950
 1.12198
 0.97791
 0.97651
 0.97721
 1.07003
 -2.  30554
 1993
 0.27256
 0.39032
 0.33712
 395639
 1.28943
 1.18270
 1.01657
 1.01592
 1.01625
 1.08742
 1.61153
 1994
 0.23729
 0.39546
 0.36725
 367196
 1.31542
 1.31710
 1.02658
 1.02765
 1.02712
 1.11690
 2.67569
 1995
 0.23073
 0.38973
 0.37954
 346843
 1.34520
 1.34400
 1.00330
 1.00269
 1.00300
 1.12025
 0.29912
 1996
 0.27405
 0.39559
 0.33036
 338040
 1.39401
 1.13425
 0.94905
 0.94842
 0.94874
 1.06282
 -5.  26234
 1997
 0.25627
 0.38812
 0.35561
 338177
 1.44123
 1.24404
 1.04549
 1.04625
 1.04587
 1.11157
 4.48479
 1998
 0.26985
 0.38592
 0.34423
 345317
 1.48745
 1.17488
 0.99809
 0.99732
 0.99770
 1.10902
 -0.  22988  __________________________________________________________________________________________________________________________________________________
 Source:
 Table
 B-  10,
 Federal
 Communications
 Commission,
 Statistics
 of
 Communication
 Common
 Carriers
 [various
 years],
 Table
 B-  7,
 and
 Table
 B-
 9.
64
 65
 Federal
 Communications
 Commission
 FCC
 99-
 345
 Table
 B-  12.
 Summary
 of
 the
 Components
 of
 LECs'
 Price
 Cap
 X-  Factor
 (excluding
 the
 Consumer
 Productivity
 Dividend)
 -
 1985-  1998  _________________________________________________________________________________________________________________________________________________________________
 Year
 U.  S.
 LECs'
 LECs'
 LECs'
 TFP
 U.
 S.
 LECs'
 Input
 X-  factor
 Previous
 Nonfarm
 Output
 Input
 TFP
 Differential
 Nonfarm
 Input
 Price
 (%)
 X-  factor
 1
 Business
 Growth
 Growth
 Growth
 (%)
 Business
 Price
 Differential
 (%)
 Sector
 Rate
 (%)
 Rate
 (%)
 Rate
 (%)
 Sector
 Growth
 (%)
 TFP
 Input
 Rate
 (%)
 Growth
 Price
 Rate
 (%)
 Growth  Rate  (%)
 A
 B
 C
 D
 =
 B-  C
 E
 =
 D-  A
 F
 G
 H
 =
 F-  G
 I
 =
 E+  H
 J  _________________________________________________________________________________________________________________________________________________________________
 1986
 1.10166
 3.19590
 -3.  47804
 6.67394
 5.57228
 2.80830
 -3.  15211
 5.96041
 11.53269
 -0.  5
 1987
 -0.  39920
 3.77146
 0.58715
 3.18431
 3.58351
 2.53178
 1.92376
 0.60802
 4.19153
 5.0
 1988
 0.29955
 6.51202
 5.73029
 0.78173
 0.48218
 3.72958
 2.39282
 1.33676
 1.81894
 5.0
 1989
 0.19920
 4.38736
 3.61531
 0.77206
 0.57285
 3.03629
 -1.  52894
 4.56522
 5.13808
 7.9
 1990
 -0.  69895
 4.76646
 0.01899
 4.74748
 5.44643
 3.30913
 3.88344
 -0.  57432
 4.87211
 8.8
 1991
 -1.  41274
 2.60725
 2.60077
 0.00647
 1.41921
 2.05824
 -0.  13437
 2.19261
 3.61182
 5.8
 1992
 1.61294
 3.51159
 -2.  30554
 5.81713
 4.20419
 2.88104
 -1.  36727
 4.24830
 8.45250
 3.4
 1993
 0.09995
 5.83651
 1.61153
 4.22497
 4.12502
 3.71664
 -0.  64768
 4.36432
 8.48934
 4.7
 1994
 0.39880
 5.41052
 2.67569
 2.73483
 2.33603
 3.50341
 2.22171
 1.28171
 3.61774
 5.4
 1995
 0.29806
 5.98969
 0.29912
 5.69056
 5.39250
 1.96268
 0.84015
 1.12253
 6.51503
 6.8
 1996
 1.47713
 8.21568
 -5.  26234
 13.47802
 12.00089
 1.38258
 5.65415
 -4.  27157
 7.72932
 1997
 0.39024
 9.46127
 4.48479
 4.97648
 4.58623
 1.89887
 -0.  22680
 2.125670
 6.71190
 1998
 0.59259
 5.37568
 -0.  22988
 5.60556
 5.01297
 0.71810
 0.18976
 0.52834
 5.54131
 avg
 2
 (86-  98)
 4.21033
 1.80677
 6.01710
 var  3
 (86-  98)
 8.08404
 6.48203
 6.22591
 avg(  91-
 98)
 4.88463
 1.44899
 6.33362
65
 66
 Federal
 Communications
 Commission
 FCC
 99-
 345
 var(  91-
 98)
 8.81863
 6.38164
 3.33409
 avg(  86-
 95)
 3.31342
 2.51056
 5.82398
 5.23
 var(  86-
 95)
 3.55698
 4.06310
 7.69230
 5.93
 avg(  91-
 95)
 3.49539
 2.64189
 6.13729
 5.22
 var(  91-
 95)
 2.03050
 1.98155
 4.75223
 1.29  _________________________________________________________________________________________________________________________________________________________________
 1
 X-
 factor
 reported
 in
 the
 1997
 Price
 Cap
 Review
 Order.
 2
 avg
 denotes
 the
 arithmetic
 mean
 of
 the
 series.
 3
 var
 denotes
 the
 variance
 of
 the
 series.
 Source:
 Bureau
 of
 Labor
 Statistics'
 Multifactor
 Productivity
 Table
 2:
 Private
 Nonfarm
 Business:
 Productivity
 and
 Related
 Indexes
 (annual
 and
 quarterly
 tables),
 Table
 B-  4,
 Table
 B-  11,
 and
 Table
 B-  13.
66
 67
 Federal
 Communications
 Commission
 FCC
 99-
 345
 Table
 B-  13.
 Total
 LEC
 Input
 Price
 Index
 -
 1985-  1998  __________________________________________________________________________________________________________________________________________________
 Year
 Labor
 Capital
 Materials
 Labor
 Capital
 Materials
 Laspeyres
 Paasche
 Fisher
 Fisher
 Growth
 Share
 Share
 Share
 Price
 Price
 Price
 Input
 Input
 Ideal
 Ideal
 Rate
 (%)
 Index
 Index
 Index
 Price
 Price
 Input
 Chained
 Index
 Index
 Price
 Input
 Index
 Price  Index  __________________________________________________________________________________________________________________________________________________
 1985
 0.31969
 0.42455
 0.25576
 1
 1
 1
 1
 1
 1
 1
 1986
 0.33511
 0.42567
 0.23922
 1.02819
 0.89271
 1.03135
 0.97148
 0.96647
 0.96897
 0.96897
 -3.  15211
 1987
 0.33052
 0.43691
 0.23256
 1.05447
 0.90146
 1.05353
 1.01788
 1.01768
 1.01778
 0.98620
 1.76258
 1988
 0.30773
 0.42453
 0.26773
 1.08234
 0.91297
 1.08639
 1.02157
 1.02184
 1.02170
 1.00760
 2.14711
 1989
 0.29341
 0.41160
 0.29499
 1.08797
 0.88304
 1.12623
 0.99750
 0.99801
 0.99776
 1.00534
 -0.  22468
 1990
 0.29395
 0.41117
 0.29488
 1.17754
 0.89133
 1.17203
 1.04001
 1.03918
 1.03960
 1.04515
 3.88344
 1991
 0.26968
 0.40119
 0.32913
 1.18570
 0.86555
 1.20494
 0.99842
 0.99889
 0.99866
 1.04375
 -0.  13437
 1992
 0.27367
 0.40857
 0.31776
 1.17037
 0.82779
 1.23480
 0.98717
 0.98567
 0.98642
 1.02958
 -1.  36727
 1993
 0.27256
 0.39032
 0.33712
 1.22361
 0.77944
 1.25535
 0.99388
 0.99321
 0.99354
 1.02293
 -0.  64768
 1994
 0.23729
 0.39546
 0.36725
 1.20706
 0.81121
 1.29144
 1.02192
 1.02302
 1.02247
 1.04591
 2.22171
 1995
 0.23073
 0.38973
 0.37954
 1.25564
 0.79187
 1.32167
 1.00872
 1.00816
 1.00844
 1.05473
 0.84015
 1996
 0.27405
 0.39559
 0.33036
 1.52821
 0.78497
 1.36140
 1.05810
 1.05824
 1.05817
 1.11609
 5.65415
 1997
 0.25627
 0.38812
 0.35561
 1.49199
 0.77622
 1.39550
 0.99737
 0.99810
 0.99773
 1.11356
 -0.  22680
 1998
 0.26985
 0.38592
 0.34423
 1.53897
 0.74675
 1.43074
 1.00231
 1.00149
 1.00190
 1.11568
 0.18976  __________________________________________________________________________________________________________________________________________________
 Source:
 Table
 B-  10,
 Table
 B-  5,
 Table
 B-  8,
 and
 Table
 B-  9.
67
 68
 Federal  Communications  Commission  FCC  99-  345
 Appendix  C
 The  Staff  Imputed  X  Study
 Florence  Setzer
 This  study  estimates  an  X-  factor  for  LEC  price  caps  by  solving  for  the  past  X-  factor  that  would  have  allowed  price  cap  LECs  on  average  to  achieve  the  return  they  would  have  had  if  they  had  been
 subject  to  competitive  market  forces.  The  study  is  based  on  the  reported  interstate  operating  revenues,  operating  expenses,  and  average  net  investment  of  price  cap  LECs  and  on  an  estimate  of  the  elasticity  of
 demand  for  interstate  telephone  services.  The  calculations  show  the  effects  on  the  revenues  and  operating  income  of  price  cap  LECs,  as  well  as  on  the  welfare  of  consumers  of  telecommunications  services,  of
 setting  the  X-  factor  at  a  level  producing  a  competitive  return.  These  calculations  assume  that  the  hypothetical  X-  factor  remained  in  effect  from  the  inception  of  price  caps  in  1991  through  the  end  of  the
 period.  An  adjustment  is  made  for  the  change  in  the  quantity  of  output  sold  as  a  response  to  changes  in  price.  In  order  to  examine  trends  over  time  in  the  rate  of  productivity  growth,  the  study  also  calculates  for
 individual  years  the  X-  factor  that  would  have  been  necessary  to  prevent  the  rate  of  return  from  rising  above  that  of  the  previous  year.  For  comparison  with  the  1997  and  1999  TFP  Studies,  calculations  were
 also  made  assuming  no  demand  response  and  using  data  for  the  RBOCs  only,  rather  than  for  all  price  cap  LECs.  Calculations  were  performed  for  1995,  for  comparison  with  the  1997  TFP  study,  and  for  1998,  to
 make  use  of  the  most  recent  data  available.
 The  effects  of  a  hypothetical  X-  factor  are  estimated  by  first  calculating  the  change  in  price,  output,  and  revenue  that  would  have  occurred  in  each  year  if  that  X-  factor  had  been  in  effect.  The
 calculation  of  these  effects  for  an  X-  factor  of  6.5  percent,  the  X-  factor  (including  CPD)  chosen  in  the  1997  Price  Cap  Review  Order,  1  is  shown  in  Table  C-  1.  Separate  calculations  are  made  for  some  carriers
 because  not  all  carriers  chose  the  same  X-  factor  during  the  period  of  sharing,  so  that  the  effects  of  moving  to  a  new  X-  factor  differ  among  carriers.  The  second  column  of  Table  C-  1  shows  the  actual  X-  factor,
 taken  from  Tariff  Review  Plan  (  TRP)  data  submitted  by  the  carriers.  A  minimum  X-  factor  of  4.0  percent  is  used  because  that  level  was  imposed  retroactively  by  the  Commission  on  carriers  that  chose
 lower  X-  factors.  2  The  difference  between  the  actual  and  hypothetical  X-  factors  is  shown  in  the  third  column.  The  fourth  column  is  an  index  of  the  cumulative  price  change  over  time  resulting  from  the
 change  in  the  X-  factor.  The  fifth  column  shows  the  percentage  change  in  price  in  each  year  relative  to  the  actual  price  in  that  year  resulting  from  the  cumulative  effect  of  the  changed  X-  factor.  If  the  6.5  percent
 X-  factor  had  been  in  effect  for  the  entire  price  cap  period,  prices  would  have  been  between  10.7  percent  and  11.79  percent  lower  than  they  actually  were  in  1998.
 The  last  two  columns  of  Table  C-  1  show  the  change  in  output  and  revenue  resulting  from  a  given  X-  factor  change.  Because  X-  factors  change  on  July  1,  the  beginning  of  the  tariff  year,  an  average  of  the
 1  Price  Cap  Performance  Review  for  Local  Exchange  Carriers,  Fourth  Report  and  Order  in  CC  Docket
 No.  94-  1  and  Second  Report  and  Order  in  CC  Docket  No.  96-  262,  12  FCC  Rcd  16642,  16697  (1997)  ("  1997  Price  Cap  Review  Order").
 2  Price  Cap  Performance  Review  for  Local  Exchange  Carriers,  First  Report  and  Order,  CC  Docket  No.
 94-  1,  10  FCC  Rcd  8961,  8971  (1995)  ("  1995  Price  Cap  Review  Order").
68
 69
 Federal  Communications  Commission  FCC  99-  345
 prices,  both  actual  and  hypothetical,  in  adjacent  tariff  years  is  used  in  the  calculation.  The  percentage  change  in  output  was  calculated  by  assuming  that  a  1  percent  reduction  in  price  results  in  an  increase  in
 output  purchased  of  0.2  percent.  3  This  assumes  that  all  reductions  in  access  prices  are  passed  on  to  interstate  end-  user  customers.  The  percentage  change  in  revenue  is  calculated  taking  account  of  both  the
 price  change  and  the  output  change.  4
 The  effects  of  changes  in  the  X-  factor  are  calculated  separately  for  each  carrier  using  data  on  operating  revenue,  operating  expense,  and  average  net  investment  reported  by  the  carriers  on  FCC  Form
 492-  A.  These  data  are  shown  in  Table  C-  2  for  1995  and  1998.  Aggregate  results  are  shown  in  Table  C-  3.  For  each  carrier,  adjusted  operating  revenue  under  the  hypothetical  X-  factor  is  calculated  by  adjusting
 actual  revenue  for  the  change  in  price  and  level  of  output,  as  reflected  in  the  final  column  of  Table  C-  1.  Operating  expense  is  adjusted  for  the  change  in  federal  and  state  taxes,  which  together  are  assumed  to  be
 39  percent  of  revenues.  We  have  no  evidence  of  the  effects  of  an  increase  in  output  on  costs,  but  short-run  marginal  costs  are  generally  believed  to  be  very  low.  5  Consequently  we  assume  that  costs  other  than
 taxes  are  unchanged  by  the  increase  in  output,  and  make  no  further  adjustments  in  operating  expense.
 Adjusted  operating  expense  is  subtracted  from  adjusted  operating  revenue  to  give  after-  tax  profits,  which  are  reported  as  adjusted  operating  income.  Adjusted  operating  income  and  average  net
 3  We  assume  that  access  costs  constitute  40  percent  of  the  costs  of  interstate  service  and  that  the  short-  run
 price  elasticity  of  demand  for  interstate  service  is  -0.  5.  Thus,  we  would  expect  the  elasticity  of  demand  for  interstate  services  with  respect  to  a  change  in  the  price  of  access  to  be  around  -0.2,  assuming  that  all  changes  in  the  price  of
 access  are  passed  on  to  end-  user  customers.  Access  charges  accounted  for  37  percent  of  AT&  T's  costs  in  1997.  FCC,  Statistics  of  Communications  Common  Carriers,  (1997/  1998  ed.)  at  3.  The  Commission  adopted  a  short-  run
 demand  elasticity  for  toll  service  of  -0.  47  in  1986.  Annual  1987  Access  Tariff  Filings,  Memorandum  Opinion  and  Order,  2  FCC  Rcd  866,  909  at  Chart  A,  p.  1  (1986).  Taylor  finds  no  evidence  that  the  toll  market  has  become  either
 more  or  less  elastic  than  in  1980.  Lester  D.  Taylor,  Telecommunications  Demand  in  Theory  and  Practice  259  (1994).  In  a  recent  paper,  using  data  from  1984  through  1993,  Kahai,  Kaserman  and  Mayo  estimated  the  short-  run
 market  demand  elasticity  for  interstate  long-  distance  service  to  be  -0.  49.  They  note  that  Taylor  reports  a  range  of  demand  elasticities  in  recent  studies  lying,  in  general,  between  0.  5  and  0.  75  for  intraLATA  toll  calling.  Simran  K.
 Kahai  et  al.,  Is  the  "Dominant  Firm"  Dominant?  An  Empirical  Analysis  of  AT&  T's  Market  Power,  39  J.  L.  &  Econ.  499  (1996),  citing  Lester  D.  Taylor,  Pricing  of  Telecommunications  Services:  Comment,  8  Rev.  Ind.  Organ.  17
 (1993).  Our  estimate  falls  at  the  low  end  of  this  range,  so  that  our  estimates  of  the  increase  in  output  in  response  to  an  increase  in  the  X  factor  may  be  biased  downward,  and  the  effect  on  the  rate  of  return  may  be  biased  upward.
 Thus  a  larger  X  factor  may  be  needed  to  produce  a  given  reduction  in  the  rate  of  return.
 4  The  percentage  change  in  revenue  is  given  by:
 RCH  =  PCH  +  (1+  PCH)*  OCH
 where
 RCH  =  percentage  change  in  operating  revenue
 PCH  =  percentage  change  in  price
 OCH  =  percentage  change  in  output.
 5  Bridger  M.  Mitchell  &  Ingo  Vogelsang,  Telecommunications  Pricing:  Theory  and  Practice  14  (1991).
69
 70
 Federal  Communications  Commission  FCC  99-  345
 investment,  which  is  assumed  to  be  unchanged  by  the  increase  in  output,  are  summed  for  all  companies.  An  average  adjusted  rate  of  return  is  calculated  for  the  industry  as  the  ratio  of  adjusted  operating  income
 to  average  net  investment  for  all  firms  in  the  industry.  As  shown  in  the  first  line  of  Table  C-  3,  the  average  rate  of  return  in  1998  if  the  X-  factor  of  6.5  percent  had  been  in  effect  since  1991  would  have
 been  11.88  percent.  Thus  an  X-  factor  of  6.5  percent  for  the  entire  period  of  price  caps  would  still  have  allowed  carriers  on  average  to  earn  returns  above  the  target  rate  in  1998.
 The  benefits  to  consumers  of  the  rate  reduction  resulting  from  the  given  X-  factor  are  shown  by  the  change  in  consumer  surplus  (the  final  column  in  Table  C-  3).  The  calculation  of  consumer  surplus
 assumes  that  IXCs  pass  on  the  entire  reduction  in  access  prices  to  end-  user  customers.  The  change  in  consumer  surplus  consists  of  two  parts:  the  benefit  accruing  from  the  lower  price  of  the  amount  of  output
 originally  purchased,  and  the  benefit  accruing  from  the  additional  output  purchased  because  of  the  reduction  in  price,  which  would  have  been  forgone  had  the  price  remained  at  the  original  level.  6  Because
 of  the  increase  in  output  resulting  from  the  reduction  in  price,  the  increase  in  consumer  welfare  is  larger  than  the  reduction  in  LECs'  revenues.  If  the  6.5  percent  X-  factor  had  been  in  effect  for  the  whole  period
 beginning  in  1991,  benefits  to  consumers  from  lower  prices  in  1998  would  have  been  $2.95  billion.
 The  second  and  third  lines  of  Table  C-  3  show  the  calculation  of  the  X-  factor  required  to  produce  a  competitive  rate  of  return  in  1995  and  1998.  The  background  calculations  of  percentage  changes  in
 price,  output,  and  revenue  have  not  been  presented  because  these  calculations  can  easily  be  replicated.  The  required  rate  of  return  for  each  year  was  found  by  adjusting  the  rate  of  return  approved  by  the
 Commission  at  the  inception  of  price  caps  by  the  basis-  point  change  in  bond  rates  over  the  period  to  reflect  the  action  of  competitive  capital  markets.  7  The  precise  level  of  the  X-  factor  required  to  reach  the
 target  rate  of  return  in  each  case  was  found  by  trial  and  error.  The  estimated  X-  factor  using  data  through  1995  was  7.10  percent;  using  data  through  1998  the  required  X-  factor  was  7.71  percent.
 For  comparison  with  the  TFP  studies,  the  calculations  were  repeated  assuming  no  demand  stimulation  and  using  data  only  for  the  RBOCs.  The  results  are  shown  in  the  last  two  lines  of  Table  C-  3.
 These  calculations  show  required  X-  factors  of  6.61  percent  in  1995  and  6.97  percent  in  1998.  Note  that  these  numbers  are  lower  than  those  using  data  for  all  price  cap  LECs  and  including  a  demand  adjustment,
 6  The  change  in  consumer  surplus  is  approximated  by:
 CSCH  =  -OR*(  PCH  +  PCH*  OCH/  2)
 where
 CSCH  =  change  in  consumer  surplus
 OR  =  actual  operating  revenue
 PCH  =  percentage  change  in  price
 OCH  =  percentage  change  in  output.
 This  estimate  assumes  that  the  demand  curve  is  linear  and  that  the  income  effect  of  the  price  change  is  small.  See  Brian  R.  Binger  and  Elizabeth  Hoffman,  Microeconomics  with  Calculus  202-  211  (1985).
 7  Moody's  Baa  bond  rate,  which  was  also  used  in  the  1999  staff  TFP  study,  was  used.
70
 71
 Federal  Communications  Commission  FCC  99-  345
 but  somewhat  higher  than  those  for  the  same  time  periods  in  the  1999  staff  TFP  study.  The  data  on  which  they  are  based  have  not  been  adjusted  for  accounting  biases  in  the  data  as  have  the  TFP  data.  On  the
 other  hand,  they  are  based  on  interstate  services  only,  so  they  more  closely  reflect  price  cap  services.  This  result  suggests  that  more  accurate  data  and  assumptions  would  increase  the  TFP  estimates.
 Table  C-  4  shows  the  X-  factor  required  in  each  year  to  maintain  the  average  rate  of  return  at  the  level  of  the  previous  year.  This  single-  year  X-  factor  was  calculated  for  each  year  from  1992,  the  first  full
 year  of  price  caps,  through  1998.  To  make  this  calculation,  operating  revenues  in  each  year  were  adjusted  to  account  for  the  effects  of  sharing  and  low-  end  adjustments.  8  This  calculation  resulted  in  an  estimate  of
 the  revenues  that  would  have  resulted  from  the  action  of  a  given  X-  factor  in  the  absence  of  sharing  and  low-  end  adjustments.  Operating  expenses  were  correspondingly  adjusted  for  the  change  in  taxes.  In
 addition,  for  years  through  1994,  the  actual  X-  factor  in  effect  for  each  carrier  at  the  time,  rather  than  the  retroactive  X-  factor  imposed  later,  was  used.  9  The  X-  factor  calculation  was  performed  as  described
 above,  except  that  changes  in  output  and  revenue  were  based  on  the  difference  between  the  actual  and  hypothetical  X-  factors  in  a  given  year  rather  than  on  the  cumulative  price  level  change  from  the  beginning
 of  the  period.  As  Table  C-  4  shows,  the  X-  factor  required  to  maintain  the  rate  of  return  of  the  previous  year  trended  upward,  though  not  monotonically,  from  a  low  of  5.50  percent  in  1992  to  a  high  of  8.51
 percent  in  1998.  This  appears  to  reflect  an  increase  in  the  rate  of  productivity  growth  over  the  period  of  price  caps,  and  suggests  that  an  X-  factor  based  on  an  average  over  the  period  is  likely  to  underestimate
 the  rate  of  productivity  growth.
 8  Data  on  sharing  and  low-  end  adjustments  from  annual  TRP  submissions  were  used.  Because  TRP  data
 are  based  on  tariff  years,  which  begin  on  July  1,  and  the  other  data  underlying  the  X-  factor  calculation  are  based  on  calendar  years,  the  sharing  and  low-  end  adjustment  data  for  adjacent  tariff  years  were  averaged  for  use  with  the
 calendar  year  data.
 9  New  X-  factors  go  into  effect  at  the  beginning  of  the  tariff  year  on  July  1.  Like  the  sharing  and  low-  end
 adjustment  data,  the  actual  X-  factors  in  effect  in  the  first  six  months  and  the  last  six  months  of  the  calendar  year  were  averaged  to  arrive  at  an  estimated  actual  X-  factor  for  the  calendar  year.
71
 72
 Federal  Communications  Commission  FCC  99-  345
 Table  C-  1
 HISTORIC  PRICE,  OUTPUT,  AND  REVENUE  CHANGES  RESULTING  FROM  HYPOTHETICAL  X-  FACTOR
 Hypothetical  X-  factor  6.50%  End  user  price  elasticity  -0.5
 Access  price  elasticity*  -0.2
 CALENDAR  YEAR  Actual  X-  Factor**  X-  Factor  Change  Cumulative  Price  Index  Price  Change  Output  Change  Revenue  Change
 Ameritech,  Bell  Atlantic,  NYNEX,  SBC,  GTE,  others***
 1991  4.00%  2.50%  0.975  -2.  50%  0.25%  -1.  13%  1992  4.00%  2.50%  0.951  -4.  94%  0.74%  -3.  00%
 1993  4.00%  2.50%  0.927  -7.  31%  1.23%  -4.  98%  1994  4.00%  2.50%  0.904  -9.  63%  1.69%  -6.  92%
 1995  5.30%  1.20%  0.893  -10.72%  2.03%  -8.  35%  1996  5.30%  1.20%  0.882  -11.79%  2.25%  -9.  25%
 1997  6.50%  0.00%  0.882  -11.79%  2.36%  -9.  71%  1998  6.50%  0.00%  0.882  -11.79%  2.36%  -9.  71%
 BellSouth
 1991  4.00%  2.50%  0.975  -2.  50%  0.25%  -1.  13%  1992  4.30%  2.20%  0.954  -4.  65%  0.71%  -2.  88%
 1993  4.00%  2.50%  0.930  -7.  03%  1.17%  -4.  74%  1994  4.00%  2.50%  0.906  -9.  35%  1.64%  -6.  69%
 1995  5.30%  1.20%  0.896  -10.44%  1.98%  -8.  11%  1996  5.30%  1.20%  0.885  -11.52%  2.20%  -9.  02%
 1997  6.50%  0.00%  0.885  -11.52%  2.30%  -9.  48%  1998  6.50%  0.00%  0.885  -11.52%  2.30%  -9.  48%
 Pacific  Telesis
 1991  4.30%  2.20%  0.978  -2.  20%  0.22%  -0.  99%  1992  4.30%  2.20%  0.956  -4.  35%  0.66%  -2.  64%
 1993  4.00%  2.50%  0.933  -6.  74%  1.11%  -4.  50%  1994  4.00%  2.50%  0.909  -9.  07%  1.58%  -6.  45%
 1995  5.30%  1.20%  0.898  -10.17%  1.92%  -7.  88%  1996  5.30%  1.20%  0.888  -11.24%  2.14%  -8.  79%
 1997  6.50%  0.00%  0.888  -11.24%  2.25%  -9.  25%  1998  6.50%  0.00%  0.888  -11.24%  2.25%  -9.  25%
 U  S  West
 1991  4.30%  2.20%  0.978  -2.  20%  0.22%  -0.  99%  1992  4.30%  2.20%  0.956  -4.  35%  0.66%  -2.  64%
 1993  4.30%  2.20%  0.935  -6.  46%  1.08%  -4.  38%  1994  4.30%  2.20%  0.915  -8.  51%  1.50%  -6.  10%
 1995  5.30%  1.20%  0.904  -9.  61%  1.81%  -7.  41%  1996  5.30%  1.20%  0.893  -10.70%  2.03%  -8.  33%
 1997  6.50%  0.00%  0.893  -10.70%  2.14%  -8.  79%  1998  6.50%  0.00%  0.893  -10.70%  2.14%  -8.  79%
 Sprint
 1991  4.00%  2.50%  0.975  -2.  50%  0.25%  -1.  13%  1992  4.00%  2.50%  0.951  -4.  94%  0.74%  -3.  00%
 1993  4.00%  2.50%  0.927  -7.  31%  1.23%  -4.  98%  1994  4.07%  2.43%  0.904  -9.  56%  1.69%  -6.  89%
 1995  5.30%  1.20%  0.894  -10.65%  2.02%  -8.  29%  1996  5.30%  1.20%  0.883  -11.72%  2.24%  -9.  20%
 1997  6.50%  0.00%  0.883  -11.72%  2.34%  -9.  65%  1998  6.50%  0.00%  0.883  -11.72%  2.34%  -9.  65%
 Source:  See  text  *  Assumes  access  =  40%  of  IXC  costs,  and  all  price  reductions  passed  on  to  end  user  customers.
 **  In  effect  7/  1  of  each  year  ***  Assumes  others  chose  lowest  X-  factor  1991-  1994
72
 73
 Federal  Communications  Commission  FCC  99-  345
 Table  C-  2
 FINANCIAL  DATA  FOR  PRICE  CAP  LECS
 Price  Cap
 Company
 Operating  Revenue*
 (000)
 Operating  Expense
 (000)
 Average  Net  Investment
 (000)
 1995
 Ameritech  $2,314,807  $1,795,638  $3,093,308  Bell  Atlantic  $6,177,664  $5,121,678  $8,122,916
 BellSouth  $3,341,690  $2,613,050  $4,618,137  Pacific  Telesis  $1,742,343  $1,346,448  $2,505,561
 SBC  $2,091,805  $1,646,644  $3,327,268  U  S  West  $2,416,832  $1,954,164  $3,855,836
 GTE  $2,729,239  $2,195,426  $4,422,624  Sprint  $1,028,598  $778,  826  $1,335,617
 Others  $498,  379  $403,  046  $728,  670
 All  $22,341,357  $17,854,920  $32,009,937
 1998
 Ameritech  $2,553,594  $1,918,674  $2,794,765  Bell  Atlantic  $6,453,096  $5,378,333  $8,380,851
 BellSouth  $3,794,553  $2,842,101  $4,578,390  Pacific  Telesis  $2,027,231  $1,639,515  $2,645,273
 SBC  $2,359,902  $2,022,258  $3,407,300  U  S  West  $2,670,048  $2,089,034  $3,513,985
 GTE  $3,222,880  $2,354,224  $4,432,509  Sprint  $1,130,092  $857,  222  $1,400,433
 Others  $939,  899  $739,  759  $1,241,895
 All  $25,151,295  $19,841,120  $32,395,401
 Source:  FCC  Form  492-  A
 *  Interstate  Revenue
73
 74
 Federal
 Communications
 Commission
 FCC
 99-
 345
 Table
 C-
 3
 X-
 FACTOR
 REQUIRED
 FOR
 COMPETITIVE
 AGGREGATE
 RETURN
 Year
 X-  Factor
 Since  1991
 Actual  Operating  Revenue*  (000)
 Adjusted  Operating  Revenue  (000)
 Actual  Operating  Expense  (000)
 Adjusted  Operating  Expense**  (000)
 Actual  Operating  Income  (000)
 Adjusted  Operating  Income  (000)
 Average
 Net
 Investment  (000)
 Actual  Rate  of  Return
 Competitive  Rate  of  Return
 Change
 in  Consumer
 Surplus***  (000)
 All
 Price
 Cap
 LECs,
 Demand
 Elasticity
 =
 -0.2
 1998
 with  1997  X****
 6.50%
 $25,151,295
 $22,753,012
 $19,841,120
 $18,905,790
 $5,310,176
 $3,847,222
 $32,395,401
 16.39%
 11.88%
 $2,947,187
 1995
 7.10%
 $22,341,357
 $20,051,518
 $17,854,920
 $16,961,883
 $4,486,437
 $3,089,635
 $32,009,937
 14.02%
 9.65%
 $2,810,519
 1998
 7.71%
 $25,151,295
 $21,053,989
 $19,841,120
 $18,243,171
 $5,310,176
 $2,810,819
 $32,395,401
 16.39%
 8.68%
 $4,979,309
 RBOCs
 Only,
 No
 Demand
 Response
 1995
 6.61%
 $18,085,141
 $16,208,672
 $14,477,622
 $13,745,799
 $3,607,519
 $2,462,873
 $25,523,026
 14.13%
 9.65%
 $1,876,469
 1998
 6.97%
 $19,858,424
 $16,948,374
 $15,889,915
 $14,754,996
 $3,968,510
 $2,193,379
 $25,320,564
 15.67%
 8.66%
 $2,910,050
 Source:
 See
 text.
 *
 Interstate
 revenue.
 **
 Assumes
 federal
 +
 state
 tax
 rate
 =
 39
 percent.
 ***
 Assumes
 all
 price
 reductions
 passed
 on
 to
 end
 user
 customers.
 ****
 X-  factor
 chosen
 in
 1997
 Price
 Cap
 Review
 Order.
74
 75
 Federal  Communications  Commission  FCC  99-  345
 Table  C-  4
 X-  FACTOR  REQUIRED  TO  MAINTAIN  UNCHANGED  RATE  OF  RETURN
 FROM  PREVIOUS  YEAR
 Year  X-  Factor  (%)
 1992  5.50  1993  5.94
 1994  5.51  1995  6.83
 1996  7.90  1997  6.57
 1998  8.51
 Source:  See  text.
75