ndustries Conventional economic theory suggests that access rates in network industries promote economic efficiency only if they are based on market prices. If market- based pricing is unavailable, then the appropriate second-best solution is to base rates on the economic costs of providing access, a concept that embraces both direct incremental costs and opportunity costs. The classic rate-making approach taken by regulatory authorities, however, focuses solely on direct incremental costs and excludes opportunity costs. Even regulatory authorities that are willing in principle to regard opportunity costs in their rate-making calculus in practice eliminate opportunity costs by positing that they are zero. The following discussion analyzes the flaws in both of these approaches. 1. Direct Cost The overwhelming majority of regulatory authorities have established rates solely on the basis of direct costs. The dominant initial position was the "fair value" principle associated with the landmark decision in Smyth V. Ames, which required Networks in Telecommunications that rates be based on the replacement cost of the assets used to provide the service. The Court based its preference for replacement costs on the recognition that if the regulated entity constituted a natural monopoly, by definition no external transactions would exist that could serve as the basis for market-based pricing. 17 At the same time, parties who obtained service under a regulated rate always had the option of constructing a substitute facility. This meant that in the long run, replacement cost would tend to reflect market demand. Although in some circumstances technological and functional obsolescence could cause replacement cost to be a misleading reflection of market value, in the absence of data based on actual transactions it remained a useful proxy. As discussed in Chapter 4, pragmatic considerations of implementability led Justice Brandeis to favor basing rates on historical cost. Over the decades, regulatory authorities have employed bot