Regulatory Price-Setting in Theory and Practice Seán Lyons (sean.lyons@esri.ie), ESRI & TCD 2 December 2011 PS6: Economic & Legal Aspects of Competition.

Regulatory Price-Setting in Theory and Practice

Seán Lyons (sean.lyons@esri.ie), ESRI & TCD

2 December 2011

PS6: Economic & Legal Aspects of Competition & Regulation

Agenda

Economics of price regulation Goal 1: Preventing prices being “too high” Goal 2: Preventing prices being “too low” Goal 3: Geographical or distributional

equity; other social objectives

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Part A: Economics of price regulation

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Economic rationale for price regulation

Health warningHealth warning But...some persistent market failures can

best be addressed using sustained conduct regulation

o Usually due to presence of market power or informational problems.

Normally applied by sectoral regulators or direct legislation rather than via competition regulators

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Optimal price regulation

Optimal regulation: P=MC, if regulated firm has no fixed overheads

However, many price-regulated firms have large fixed overheads (implying increasing returns to scale)

C(Q)=cQ+K If we set price = c, firm makes a loss of K One option is to give a subsidy of K, allowing

price to be set at c; but must be financed by lump sum tax to be efficient

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Increasing returns illustration

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Green arrow shows lossto firm if P=MC

Second best approaches

Charging a price based on average cost C(Q)/Q lets firm break even, but leaves per unit price above marginal cost

Two part tariffs involve charging an access price to recover K, which allows a per unit price of c ‘First best’ only if customers are homogeneous Otherwise some customers, e.g. with low

demand, may not buy service at all Non-linear tariffs can help calibrate the mix

of access and usage prices to customer types

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Non-linear tariff illustration

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Multi-product firms

What if the regulated firm produces two goods with joint fixed costs?

Costs must be allocated between them to set prices

Equi-proportionate markups: allocate overheads in proportion to c for each good

Ramsey prices: allocate overheads in proportion to the inverse elasticity of demando i.e. services attracting greatest willingness to pay

are allocated highest share of overheado Minimises reduction in quantity demanded

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Ramsey pricing illustration

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Product A: Elastic demand Product B: Inelastic demand

Informational problems in regulation

Optimal regulatory pricing rules demand a lot of information

Regulators have imperfect information, particularly about costs

Firms can exploit informational asymmetry to extract rents

Firms worry that regulators may expropriate investments once costs are sunk

Administratively practicable methods are needed to set regulated prices and underpin credibility of policy

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Policy/competition concerns regulators wish to address

Excessive pricing Predatory pricing, margin squeeze High prices or lack of supply in high cost

geographical areas or groups of users Other reasons for preventing prices being

too low or too high (e.g. political or capture motives)

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Competing objectives Low retail prices Increased competition Efficient level of investment Efficient level of product quality Maintain incentives for innovation Allow regulated firm a normal return on capital;

ensure it can finance its operations (“financeability”)

Universal service (geographical and distributional)

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Goal 1: Preventing prices being “too high”

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Rate of return / “cost of service” regulation

allowed revenue = allowed operating expenditure +allowed rate of return x (capital stock + allowed investment)+ depreciation

Avoids excessive profits in any given year; firm’s financeability is protected

Averch-Johnson effect: firm has an incentive to over-invest in capital (“gold-plating”)

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Averch-Johnson effect

o r = user cost of capitalo w = average wageo c = average price of capital stocko K = stock of capital

Increasing the size of the capital stock allows higher profits for a given rate of return

Leads to inefficiently high capital-labour ratio

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( – – )

RoR PQ wL rK

cK

RPI-X price cap

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0.4

0.6

0.8

1

1.2

1.4

1.6

0 1 2 3 4 5

Cost

and

pric

e

Year of price control

Starting price + inflation

Starting price

Starting price + inflation -productivity growth

Actual cost

A B

C

A - cost level chosen by firm

C - controlled by regulator

B - efficiency gain retainedby firm

RPI-X price cap Provides an incentive towards greater efficiency, at least

in early years of control However, can lead to sizeable profits in some years;

issue for public perception Weaker incentives to invest than RoR control If too tight, could compromise solvency of the regulated

firm Can lead to under-provision of quality of service if no

supporting incentives/contraints included Attractive option where static inefficiency is seen to be

the main problem

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Continuum between price cap and rate of return regulation

If price cap is only for a year, it is effectively a rate of return control

Price cap incentive effect weakens as the end of the period approaches

Setting either of them requires detailed info on actual and target level of efficiency, required investment, cost of capital, etc.

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Menu regulation

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Menu regulation: offer regulated firms choice of regulatory contracts that encourage them to reveal true cost conditions they face; save on admin cost and informational demands

Example: % reward for different levels of cost performance

Ex ante cost proposal relative to regulator est.

Ex post actual cost

-10% -5% 0% +5% +10%

-10% 3.25 3.19 3.00 2.69 2.25

-5% 1.50 1.56 1.50 1.31 1.00

0% -0.25 -0.06 0 -0.06 -0.25

+5% -2.00 -1.69 -1.50 -1.44 -1.50

+10% -3.75 -3.31 -3.00 -2.81 -2.75

Adapted from Oxera (2008); for detailed discussion see Laffont & Tirole (1993)

Efficiency assessment

Traditional benchmarkingo Risks ignoring differences in local context behind firms’

results Statistical benchmarking

o Requires consistent data on firms from many jurisdictions Yardstick competition

o Can only be done in jurisdictions with a significant number of regional suppliers; requires harmonised reporting of results

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Wholesale market price regulation

Typically in the context of regulated access to facilities or services

Example: network services (non-competitive) sold to retail market (potentially competitive)

“Cost plus” – wholesale price cap based on costs of wholesale services

“Retail minus” – wholesale price cap based on discount from retail price of vertically integrated firm

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Wholesale market price regulation

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0

20

40

60

80

100

120

Network-only incumbent

Vertically integrated incumbent

Service-based Entrant

Cost of supply

Cost of network services

Related regulation of quality, access, investment and financial decisions

Quality and price are simultaneously determined in competitive markets; sometime quality omitted in regulatory controlso Quality may then be biased downward

If access is regulated, e.g. “must serve”, price will have to be regulated and vice versa

Step-in rights or special administration powers needed to ensure continuity of service and reverse incentive for over-leveraging

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Goal 2: Preventing prices being “too low”

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Regulatory tools in liberalised markets

Competition policy approacho Price < MC too low per seo Price between MC and AC requires examination

Margin squeeze – charging too much for wholesale input and/or too little for retail service such that efficient service-based entrants are excludedo Require incumbent to charge own retail unit 3rd party

wholesale priceo Margin squeeze tests

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Goal 3: Geographical or distributional equity; other social objectives

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Universal service / public service obligations

Uniform price rules with implicit cross-subsidies Vulnerable user schemes: targeted cross-

subsidies or tariff structure regulation But also more extensive interventions

o Anti-inflation measures / incomes policieso Fuel priceso Rent controlo Anti-usury laws

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Some references

Easy intro: Viscusi, Vernon & Harrington, 2005 (4th Ed.), Economics of Regulation and Antitrust, Ch.11 and first half of 12

Armstrong, Cowen and Vickers, 1994, Regulatory Reform: Economic Analysis and British Experience.

Averch, H. and and Johnson, L., 1962, “Behaviour of the firm under regulatory constraint,” AER 52(5), 1053-1069.

Oxera, 2008, Menu regulation: is it here to stay? http://www.oxera.com/cmsDocuments/Agenda_Jan08/Menu%20regulation.pdf

Advanced: Laffont and Tirole, 1993, A Theory of Incentives in Procurement and Regulation.

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