limited services in markets untouched by competition contrasted with unregulated, lower cost and more diverse services in the higher density markets served by competition. To avoid this, regulation needs to assure that the burdens of serving low density markets are more equitably shared among all carriers and that the traditional regulated carrier has the price flexibility and incentives to compete effectively in potentially competitive markets.

A final regulatory concern with increased competition is the problem of who bears the responsibility for historic investment decisions. In order to compete effectively in potentially competitive telecommunications markets, the historically regulated carriers have to take investment risks which they did not face as franchised monopolies. If, for example, cable companies are successful in providing access to telephone networks, a substantial portion of existing telephone investment in loops could become uneconomic. Moreover, in order to meet prospective competition from PCS, cellular and cable suppliers, many local exchange companies may seek to expand into the provision of entertainment and information services. If the restrictions imposed by the Modified Final Judgment are lifted, moreover, these same carriers will undoubtedly seek to expand their networks to provide interLATA service.

While some of these investments may succeed, others will undoubtedly fail as the regulated carriers succumb, in portions of their markets, to more effective competitors. Of course, these are normal business risks for suppliers in competitive markets. But under the traditional rate of return approach to regulation, the risks of these failed investments would be borne, in whole or in part, by the remaining customers of the regulated supplier. While such a system may have made good sense for suppliers with a franchise monopoly, it makes much less sense as a means of governing investment decisions in a market strongly influenced by competition. On the one hand, it subjects consumers, who have no control over investment decisions, to a level of investment risk which is likely to be intolerable. At the same time, the system is unlikely to provide sufficient incentives to assure that the correct investments are made. Some regulated firms may make excessive or unwise investments, insulated by the presumption that they can recover the investments and a return even when, after the fact, they prove unwise. Other regulated carriers may fail to undertake sufficient investments, convinced that they will recover no more than the costs of their successful investments and be forced to absorb some or all of the costs of investments which are not successful.

Faced with these challenges, many state regulatory commissions are moving to substitute price regulation for rate of return regulation. Under this approach, commissions may choose to entirely deregulate some services which appear to be subject to competition or sufficiently discretionary to not need price regulation. For the remaining regulated services, price caps are substituted for traditional cost-based regulation. In some cases, prices are capped at their current levels for a period of time after which the company gains complete or banded price flexibility. In other cases, future prices are limited by a cap which rises (or falls) at a rate governed by the difference between inflation and any anticipated difference between productivity growth in telecommunications and in the rest of the economy.