1 Price Regulation Kevin Mwongera Robert Gathogo.

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Price Regulation

Kevin Mwongera

Robert Gathogo

Objectives of Price Regulation.• Financing objectives;

– Ensure that regulated operators are permitted to earn sufficient revenue to finance on-going operations and future investments

– Disallow operators to earn revenues in excess of their revenue requirements

• Efficiency objectives– Allocative efficiency e.g. local and international call– Productive efficiency - efficient mix of inputs, minimal

inputs– Dynamic Efficiency – resource move with time

• Equity objectives. –– fair distribution of welfare benefits e.g. operator-

consumer or consumer-consumer

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Economics of Telco Prices & costsEconomic Rationale for Price Regulation• Justified when markets fail to produce

– competitive prices– Efficient markets – in allocation of scarce resources– Efficient prices where benefit consumer gets from the last unit

consumed equals marginal cost of producing it.

• The demand and supply curves are as shown overleaf• Supply curve = MC curve above AVC• Efficient Price = MC• Total surplus (ABC) = consumer surplus ( ABPx) +

producer surplus (PxBC)• Efficient markets produce the highest surplus.

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Demand, Supply and SurplusFigure 1

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Elasticity of Demand• Is the responsiveness of the demand for telecomm

services to changes in prices or incomes• Price elasticities - % Δ in Q due to small Δ in price

– 0 < § < -1 – inelastic– § > -1 – elastic– § = -1 – unitary elasticity

• Income elasticities - % Δ in Q due to small Δ in income

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Perfect Competitive MarketsCharacteristics of a perfectively competitive market.• Several sellers and buyers• No dominant buyer or seller to singly affect process• No significant externalities- spill over benefits or

negative effects from other markets• Free entry or exit• Market is not characterized by Econ of Scale or ScopeWhen the above are not met the market will not produce

efficient prices leading to market failure and hence misallocation or inefficient allocation of resources.

• Above justifies price regulation – consider also regulatory bureaucracy and cost

• Natural monopoly – due to econ of scale/scope is a market failure situation – use sub-additivity concept to determine natural monopoly

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Perfect Competitive MarketsFigure 2

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Economies of Scale and Scope• Economies of scale occur when the average cost (AC)

of a firm decrease with increase in volume produced a.k.a. increasing returns to scale. Diseconomies of scale is the vice versa.

• Economies of scope refers to the cost advantages of one operator who supplies two or more goods compared to different operators producing one good each. – arise due to the shared use of equipment or common facilities.

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(Dis)economies of ScaleFigure 2

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Monopoly Pricing• In Perfect competition P = MC• For firm with economies of scale, MC is below AC in

the relevant range hence firm cannot recoup all costs.• To maximize social welfare(producer and consumer

surplus) and allow firm to break even second-best price is chosen been the AC.

• Unregulated monopoly will set MC = MR hence monopoly. Profits and increased welfare losses.

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Monopoly PricingFigure 3

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Ramsey Pricing• First-best pricing is not commercially viable for monop.

Since MC pricing do not cover all cost• Second best (Ramsey) prices are those that equate

the amount by which the price exceeds MC in inverse relation to the elasticity of demand for each service – aka ‘inverse elasticity rule’

Figure 4

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Price Regulation• For the purpose to mimic the results of efficient

competition. Other objectives include:– Financing objectives – regulated earn sufficient revenue to

finance operations. ROR.– Efficiency Objectives – efficiency in supply of telecomm.

Allocative>>price reflect relative scarcity, productive>>most efficient mix of inputs or dynamic efficiencies>> resource move over time to their highest value uses

– Equity Objectives – fair distribution of welfare benefits. Operator-consumer equity>>btwn consumers and regulated operator. Consumer-consumer equity>>>btwn different classes of consumers e.g USO

• Rate Rebalancing- refer to moving prices for more closely to the cost of producing the service. Usually connx, subscriptions, and local calls are below cost.

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Price RegulationApproaches to price regulation - some are rules based

for stability and certainty while others are ad hoc and discretionary.

1. Discretionary• Heavily focused on achieving social, financial and economic

objectives during monopoly• Prices then set to promote consumer-to-consumer equity• Below cost prices for connection and local calls and higher

traffics for long distance and international• Follows value of service principle- buyer will pay a price

related to the value derived from the service.• Interventionist. Minister could simply reduce or increase.• Poor performance and over-staffed hence no productive,

dynamic and financing objectives – no expansion money• Leads to under-supply and long waiting lists• No operator-consumer or consumer-consumer equity• Inefficient price structures.

Rate Rebalancing.• Refers to moving the prices for different

telecommunications services more closely in line with the costs of providing each service.

• E.g. cheap local calls and expensive international calls

• Unbalanced price structures are also inefficient in that higher-than-cost prices encourage uneconomic entry by high-cost operators. Lower-than-cost prices discourage economic entry, even by low-cost operators.

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Price Regulation2. Rate of Return Regulation (ROR)

• Rules based. Provides certainty to operator to meet the revenue requirement (RR)

• Calculates RR and adjusts individual service prices so that its aggregate service revenues cover its RR

• RR = operating costs + financing (debt service) + fair return on rate base.

• Regulator to ensure that the costs were prudently incurred otherwise disallow from the rate-base

• Regulator determines ROR based on financial conditions and operator or industry-specific issues (risks, specific tax etc)

• Do not address price structure but cumulative revenues hence middle ground btwn cost-oriented and discretionary prices.

Weakenesses of ROR

• Lack of Incentive to Minimize Costs – a.k.a “cost plus regulation”. Operator has little incentive to reduce its rate base or its operating costs

• Lack of Innovation/Productivity Improvement - ROR regulation does not provide the operator with a strong incentive to increase its productivity.

• Capital Bias – The Aversch-Johnson Effect - Provides incentives to increase the amount of capital that the operator invests. Hence encourages the operator to use an inefficient input mix. productive efficiency is not being maximized.

• Cost of Regulation - Requires the operator /regulator to spend significant amounts of time/money.

• Interventionist Nature of ROR Regulation - scrutiny to prevent rate base “padding”. burden.

• Inadequacy for Transition to Competition -vertically-integrated operators have an incentive to engage in anti-competitive practices (e.g. cross-subsidization).

ROR-Incentive Regulation• Developed to respond to perceived weaknesses

in traditional ROR regulation. Regulator gives incentives to operators e.g. flexibility in cost reduction, rewards and penalties. Examples:– Banded Rate-of-Return - rather than set the rate of

return at 12%, the operator might be allowed a return of between 10% and 14%.

– Rate Case Moratoria – agree to suspend regulatory scrutiny of the operator’s earnings for a fixed period.

– Earnings-Sharing – share earnings with consumers e.g. the regulated operator keeps 100% of the earnings up to 10%, the operator and consumers split earnings between 10% and 14%. The operator’s earnings are capped at 14%.

Price Cap• Price cap regulation uses a formula to

determine the maximum allowable price increases for a regulated operator’s services for a specified number of years.

• designed to permit an operator to recover its unavoidable cost increases (e.g. inflation, tax increases, etc.)

• Does not permit the operator to increase rates to recover all costs.

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Price Regulation3. Price Cap Regulation

• Formula determines rate of change of prices from an initial level

• Allow increase equal to inflation less assumed rate of productivity due to technological improvements, lower switching and transmission costs etc

• PCIt = PCIt-1 x (1 + It - X)

Price Cap Adv. Over ROR• Price cap regulation has several advantages

over ROR regulation:It provides incentives for greater efficiency;It streamlines the regulatory process;It provides greater pricing flexibility;It reduces the possibility of regulatory intervention

and micro-management;It allows consumers and operators to share in

expected productivity gains;It protects consumers and competitors by limiting

price increases; andIt limits the opportunity for cross-subsidization.

Price Indices and Weights• When operator produce two or more services, it

will be required to keep its actual prices below a Price Cap Index (PCI).

• different services are weighted so that the prices for major services receive a proportionately greater weight.

• Calculate Actual Price Index or API• API ≤ PCI• The operator has pricing flexibility; some prices

may be increased above the weighted average of the change in prices, as long as others are not.

• Price Cap formula APIt ≤ PCIt = PCIt-1 x (1 + It - X)

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Example

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Variables – I and X• Can be forward looking or historical• Selection Criteria for an Inflation Factor

– Reflective of changes in the operator’s costs – in unstable economies

– Availability from a credible, published, independent source - credibility

– Availability on a timely basis - within 2 to 4 months.

– Understandability - easily understood– Stability – stable over periods of time– Consistency with total factor productivity of the

economy

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Price RegulationThe I factor• I is usually derived from historical data cause

– Past inflation is usually a measure of future inflation

– Expensive to derive future values of inflation

– Forecasting shall necessitate corrections to offset error.

• However there is the disadvantage of great future inflation variation – Soln. increase the frequency of measurement

• Choice of I factor should…– Reflects operators cost changes

– Credible, published and from independent source

– Available on timely basis

– Understandable

– Stable

– Consistent with total economy’s productivity

• Examples include GDP or GNP deflator, CPI, RPI,

The X-Factor• Productivity is the measure of how effectively an entity employs

inputs to produce outputs. It is a measure of operational efficiency.• TFP = Q/Z• Changes in productivity is given by Δ TFP = ΔQ/ΔZ• Example: If the output volume index has increased by 5% (i.e. Δ

Q=1.05) and the input volume index has increased by 2% (i.e. Δ Z= 1.02), the change in the TFP index is 2.94%: i.e. Δ TFP = 1.05/1.02 = 1.0294

• Productivity factor is divided into the “basic offset” and adjustment factors.

• The basic offset should reflect the regulated operator’s historical achievement of productivity growth e.g. If the operator has had a history of lower input price inflation than other firms in the economy, that should be reflected in the basic offset.

• Adjustment factors are included to take into account changes in the operating environment of the regulated operator e.g. an adjustment factor might reflect the introduction of price cap regulation, the introduction of competition or the privatization of the operator.

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Price RegulationOthers

The Z factor• Exogenous factor to cater for significant change in input prices outside

operators control and not captured in I-factor e.g big increase in excise duty

The Q factor• Quality of service (QOS) factor to cater for the provided QOS provided

by the operator