To hasten the development of competition, the Telecommunications Act of 1996 enacted in the United States (US) and similar acts ratified by governments around the world ordered incumbent local carriers to provide competitors with access to their networks. This access can be in the form of interconnection or unbundled network elements and can be in the form of any technically feasible point in an incumbent’s network. However, due to its high initial capital outlay, potential competitors are most interested in obtaining access to the incumbent’s local loop networks.

To facilitate access to the local loop, incumbents are being forced to “unbundle” it. With local loop unbundling, incumbents must allow competing providers to connect, on a leased basis, to network elements in their local loop networks. With the availability of these unbundled network elements at regulated lease rates, competitive local exchange carries now are able to defer most of the capital outlay they would have been required to invest in constructing their own loops. This allows the new entrants to enjoy significant capital savings while retaining the option value inherent in deferring a commitment to any particular infrastructure or technology.

The lease rates, or prices, for these unbundled network elements have a dramatic impact on social welfare. As in any economic pricing situation, if prices are set too low, the seller (in this case the incumbent carrier) is deprived of an opportunity to recover its costs. Conversely, if prices are set too high, competitive entry might only occur via facility-based carriers and, thus, will not be as widespread as desired by legislators and regulators.

Regulators have a number of pricing options available for setting the lease rate for unbundled network elements. In Europe, member countries of the European Union appear to favor prices based on long-run incremental costs but have not yet specified a specific methodology or established default proxy prices. In the US, the Federal Communications Commission opted to establish prices based on a methodology they devised—called total element long run incremental cost (TELRIC).

The purpose of this paper is to investigate the usefulness of cost proxy models in accurately estimating the economic costs of unbundled network elements. It illustrates some of the theoretical and practical shortfalls of cost proxy models and offers some analytical tools that can be used to evaluate these models.