Regulation and Competition of Telecommunication Networks Dr. Nikolaos Lionis University of Athens Panteion University March 2011
Welcome message from author
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
Regulation and Competition of Telecommunication Networks
Dr. Nikolaos Lionis University of Athens Panteion University
March 2011
2
Contents
1. The Perspective of the Course ................................................. 5
1.1. Structure – Conduct – Performance .......................................... 5
2. A Brief Description of the Telecommunications Industry ..... 6
2.1. Telecommunications Networks ................................................. 6
2.2. Main Sectors of the Industry ...................................................... 7
2.3. Main Characteristics of the Industry ......................................... 8
3. Reform of the Industry ............................................................. 9
3.1. Telecommunications in the US ................................................ 10
3.2. Telecommunications in the UK ................................................ 11 3.3. Telecommunications in New Zealand ...................................... 12
4. Network Utilities ..................................................................... 13
4.1. Public Utilities & Public Goods ................................................. 14
4.1.1. Possibility of Exclusion ....................................................... 14
4.1.2. Desirability of Exclusion .................................................... 14
4.1.3. Market (Private) Provision and Market Failure ................ 16
4.2. Network Industries and Network Goods.................................. 17
4.2.1. Basic Elements of Networks ............................................... 17
4.2.2. Classification of Networks ................................................. 18
4.2.3. Main Characteristics of Network Goods ...........................19
4.2.4. Complementarity and Compatibility ............................... 20
4.2.5. Consumption Externalities ................................................ 21
4.2.6. Switching Costs and Lock-in............................................. 22
4.2.7. Significant Economies of Scale ......................................... 23
5. Natural Monopoly .................................................................. 24
5.1. Single product Natural Monopoly ........................................... 25
5.2. Multiproduct Natural Monopoly ............................................. 26
6. Monopoly Power and Inefficiencies ...................................... 27
7. Government Intervention ...................................................... 28
7.1. Microeconomic Policies ........................................................... 28
8. Direct Market Control ............................................................ 29
3
8.1. Public Enterprises ..................................................................... 30
9. Control Market Efficiency ....................................................... 31
9.1. Regulation Policy ....................................................................... 31 9.2. Competition Policy ................................................................... 32
9.3. Regulation vs. Competition Policy .......................................... 33
10. Efficiency of Ownership Structures ....................................... 34
10.1. A Simple Model ........................................................................ 34
10.1.1. Private Ownership ............................................................. 34
10.1.2. Public Ownership .............................................................. 34
10.1.3. Private vs. Public ............................................................... 35
10.2. Public vs. Private Ownership ................................................... 36
10.2.1. Principal Agent Problem ................................................... 36
10.3. Social Welfare Objective .......................................................... 37
10.3.1. A Model of Privatization and Political Control ................ 37
11. Methods of Privatization ........................................................ 40
12. Regulation with Full Information .......................................... 42
12.1. Single Product Monopoly ......................................................... 42
12.2. Multi Product Monopoly .......................................................... 43
13. Regulation with Asymmetric Information ............................ 45
13.1. Regulation with Money Transfers............................................ 46
13.2. Power of the incentive scheme ................................................ 47
13.3. Designing the regulatory policy under asymmetric information .......................................................................................... 49
13.4. Factors Limiting the Power of Incentives ................................ 50
13.4.1. Quality Concerns ............................................................... 50
13.4.2. Regulatory Commitment .................................................. 50
13.4.3. Regulatory Capture ............................................................. 51
13.5. Regulation in Practice .............................................................. 52
13.5.1. Rate of Return Regulation ................................................. 52
13.5.2. Perfect Price Cap Regulation ............................................ 53
14. Essential Facility and Access .................................................. 54
14.1. The Cost Recovery Problem ..................................................... 55
4
14.2. First Best Solution .................................................................... 56
14.3. Ramsey Pricing ......................................................................... 57
14.4. Efficient Component Pricing Rule ........................................... 59
14.5. Asymmetric Information ........................................................... 61 14.6. Dynamic Pricing Rules ............................................................. 62
14.6.1. Backward Looking Cost Based Access Pricing Rules ....... 63
14.6.2. Forward Looking Access Pricing Rules ......................... 64
14.7. Global Price Cap ....................................................................... 65
5
1. The Perspective of the Course
The course will investigate the central principles that underlie the design of regulation and competition policy in network industries.
1.1. Structure – Conduct – Performance
6
2. A Brief Description of the Telecommunications Industry
2.1. Telecommunications Networks
A telecommunications network is a collection of terminals, links and nodes which connect together to enable telecommunication between users of the terminals. The links connect the nodes together and are themselves built upon an underlying transmission network which physically pushes the message across the link.
7
2.2. Main Sectors of the Industry
1. Network Operation Combination of links and switches (exchanges) which enable communication between one point and another
Local Fixed Network
Long Distance Network
Local Mobile Network
2. Service Provision Using the network to provide various communication services to end users
Basic voice telephony
Enhanced services (premium rate services, automatic call back, number identification, voice messaging, selective routing of calls, video conference, video on demand, television services, internet, email, data transfer etc.)
3. Apparatus and Equipment
For end users (phones, mobile phones, answering & fax machines, telex, TV sets, computers etc)
For network development (switches, cables etc.)
8
2.3. Main Characteristics of the Industry
Cost structure - Large fixed costs – Small marginal costs - Some segments are technologically natural monopoly
(bottleneck, essential facility)
Technology is progressing rapidly - Technical complexity - Bottlenecks change with technological evolution - Multiplication of networks - New services
Evolution of industry structure - Started with a dominant operator and hence an entrenched
monopolistic supply structure and specific market failures - Technological progress determines industrial structure
Important policy issues - Compatibility and Interconnection - Network Development and Maintenance - Universal Service Obligation
9
3. Reform of the Industry
1. State owned monopoly
2. First Fundamental Reform
Privatization of incumbent operators
Incentives to minimize cost
Pricing according to business and economic principles
3. Second Fundamental Reform
Liberalization
Deregulation
Main objectives 1. Universal accessibility to basic telephone service at affordable
prices.
2. Opportunity for telephone company shareholders to earn a reasonable return on their investment.
3. Equitable treatment of subscribers in terms of service and price.
4. Assurance that telephone companies do not unfairly take advantage of their monopoly dealings with competitors.
5. Encouragement of the development and widespread availability of new technology and innovative services to respond to the needs of business and residence customers.
10
3.1. Telecommunications in the US
1. Private Monopoly (1876 – 1894)
1876: Bell System gains Patent Protection
1881: Bell System acquires Western Electric (apparatus production)
1885: AT&T is established (long distance market)
2. Free Competition (1894 – 1921)
1894: End of patent protection
1910: 10.000 telecommunications companies
Compatibility problems
1921: Willis Graham Act – Mergers
3. Private Regulated “Monopoly” (1930 – 1984)
1934: Telecommunications Act - Federal Communication Commission is established - Universal service and fair pricing
AT&T dominates (Bell Labs, Western Electric, 22 Bell Operating Companies)
1949: 1st Antitrust suit – Illegal exclusion by buying all apparatus and equipment from Western Electric (settled in 1956)
1974: 2nd Antitrust suit - Illegal exclusion with Western Electric; monopoly in the long distance market; refused to interconnect competitors and customers; other discriminatory practices that raised competitors' costs; predatory pricing; refused to provide information to regulators (final judgment 1982)
1983: 1.459 companies mainly in local markets MCI and GTE - Sprint in long distance market Monopoly in apparatus and equipment market
4. Competition and Deregulation (1984 – today)
1984: AT&T breakup - AT&T (long distance operations, Western Electric, Bell
Labs) - 7 Regional Bell Operating Companies (restricted to local
telephone services
1996: Telecommunications Act – Promotion of competition in
all markets
11
3.2. Telecommunications in the UK
1. Public Monopoly Period
1981: BT and Post Office separation
2. Duopoly Period
1982: Mercury is licensed as a national network operator but launches its service not before 1986
1983: BT-Mercury duopoly policy announced
1984: 50,2% of BT's shares are sold More shares are sold in 1991 BT is totally privatized in 1993 BT is kept vertically integrated
1984: Regulatory authority (Oftel) is established Emphasis in price controls
1984: Duopoly also in mobile telephony Cellnet, Vodafone (analog licenses)
1985: Oftel rules interconnection between Mercury and BT
1987: BT's service quality under criticism BT accepts liability for poor services in 1988
3. Market liberalization
1991: Duopoly policy ends
1991: Two new licenses for mobile telephony Mercury, Orange (GSM licenses) Vodafone gets GSM license
Price control extended to international calls; Controversy over interconnection terms
1992: Several new fixed link operators are licensed (cable TV companies)
1996: Fixed wireless services (Ionica)
12
3.3. Telecommunications in New Zealand
Telecom - Public monopoly
1989: Market Liberalization - Clear in long distance market - Bellsouth New Zealand in mobile market (GSM)
1990: Telecom is privatized - Small share is kept for universal service program
No regulatory authority is established
Effective competition is meant to be secured by Competition Policy
Interconnection charges - Direct negotiations - Court intervention under Competition Law
13
4. Network Utilities
Network A system of interconnected/intersecting components or lines.
Public Utilities A business/organization that furnishes an everyday necessity to the public at large.
14
4.1. Public Utilities & Public Goods
Public Goods have two distinct aspects:
1. Exclusion is impossible 2. Exclusion is undesirable
4.1.1. Possibility of Exclusion
Whether the consumption of a given good can be rationed (i.e. whether its consumption can be denied to a given agent)
Exclusion is impossible - National defense, public health
Exclusion is extremely costly - Parks, forests
4.1.2. Desirability of Exclusion
Whether it is desirable to ration consumption
Exclusion is undesirable for economic reasons (non-rivalry) - Consumption by an agent does not reduce the available
quantity and, thus, the possibilities of consumption by other agents (non-rival goods)
- The marginal cost of offering the good to an additional consumer is zero
Exclusion is undesirable for social reasons - Publicly provided private goods (education, health care)
Are Public Utilities a Public Good?
15
Pure and None Pure Public Goods
16
4.1.3. Market (Private) Provision and Market Failure
Free riding problem Consumers have no incentive to contribute (buy) the good in the hope that other consumers will do so
Complete market failure Nobody (or too few) contribute and, thus, there is no production at all
Underprovision Setting a price results in underutilization of the good
Underprovision of Public Good
17
4.2. Network Industries and Network Goods
4.2.1. Basic Elements of Networks
Networks are composed of links that connect nodes. - Physical: Telephone, Fax, ATM networks, Internet, etc. - Virtual: networks of users of compatible and complementary
goods; video recorders and videotapes, hardware and software, cars and repair parts, etc.
Many components of a network are required for the provision of a typical service.
Thus, network components are complementary to each other.
A phone call from A to B is composed of AS (access to the switch of customer A), BS (access to the switch of customer B), and switching services at S.
18
4.2.2. Classification of Networks
The classification in network type is not a function of the topological structure of the network. Rather, it depends on the interpretation of the structure to represent a specific service.
Two way networks Services AB and BA are distinct. (railroad, road, many telecommunications networks etc.)
One way networks When one of AB or BA is unfeasible, or does not make economic sense, or when there is no sense of direction in the network so that AB and BA are identical. (broadcasting, paging etc.)
19
4.2.3. Main Characteristics of Network Goods
1. Complementarity and compatibility
2. Consumption externalities
3. Switching costs and lock-in
4. Significant economies of scale in production
20
4.2.4. Complementarity and Compatibility
Complementary goods are goods that are always consumed together
Consumers are shopping for systems rather than individual products
Complementary goods must be compatible, i.e. must operate on the same standard
Need for coordination of competitors on standards
Anticompetitive behavior - Coordination has the potential of creating anticompetitive
behavior
21
4.2.5. Consumption Externalities
Network externalities or adoption externalities
Interdependency of consumers
Positive externalities
The utility derived from the consumption of these goods is affected by the number of other people using these or compatible goods
The larger the network, the stronger the effect
Multiple equilibria - Unstable equilibrium: if one leaves several others follow and if
one subscribes several others follow - Smallest unstable equilibrium: It is the critical size of the
network. If this threshold is not reached then the network cannot exist.
(N: Actual members, n: would like to be members, p: entry fee)
22
4.2.6. Switching Costs and Lock-in
Cost of switching to a different service or adoption a new technology
Switching costs imply that consumers are locked in
The degree of lock in depends on the magnitude of switching costs
Types of switching costs - Compatibility - Transaction costs - Contracts - Training and learning - Search costs - Loyalty costs - Psychological costs
Affect price competition - Before lock-in: Intense competition to attract consumers
- After lock-in: Less competition (consumers will not switch
unless the utility difference exceeds the switching cost)
23
4.2.7. Significant Economies of Scale
Economies of scale
Very high fixed sunk cost, together with almost negligible marginal cost
Average cost function declines sharply
Imperfect competitive market - Competitive equilibrium does not exist - Dominant leaders capture most of the market
24
5. Natural Monopoly
Single firm production minimizes costs
An industry is a natural monopoly when one firm is viable but not two or more
Policy trade-off: Least cost production vs. monopoly power distortions
25
5.1. Single product Natural Monopoly
Economies of scale: Increasing returns to scale in production
An industry is a natural monopoly when there exist increasing returns to scale and, as a result, decreasing long run average cost
Permanent natural monopoly
LRAC declines continuously as output increases
Temporary natural monopoly
LRAC declines up to a given output and then becomes constant thereafter
26
5.2. Multiproduct Natural Monopoly
Economies of scope: Subadditivity of cost function
An industry is a natural monopoly when the cost function is subadditive
Unsustainable natural monopoly: A potential entrant can enter and make a positive profit.
Sustainable natural monopoly: No potential entrant can make a profit by undercutting the incumbent's price.
27
6. Monopoly Power and Inefficiencies
Deadweight welfare loss: too little output - too high price
Income distributional objectives
Wasteful rent-seeking behavior: Costs of having and maintaining a monopoly position - Excessive R&D leading to a patent - Bribes to politicians for getting exclusive rights - Advertising - Resources needed to preempt potential entrants - Lobbying costs to convince that monopoly is not harmful
Low cost efficiency due to quiet life - little attention to cost cutting strategies - managerial slack
Innovation and dynamic efficiency - Darwinian view: It is competition that induces firms to
innovate and to be efficient and thereby the economy to grow - Schumpeterian view: It is the existence of future monopoly
rents that induces firms to innovate and thereby the economy to grow
Commercial arrangements between monopoly and consumers - product bundling and tying - price discrimination - volume discounts
Commercial arrangements between monopoly and downstream firms - exclusivity conditions - refusals to sell - long term contracting
28
7. Government Intervention
7.1. Microeconomic Policies
1. Market Control
Public Enterprises
2. Control Market Efficiency
Regulation Policy (Ex ante)
Competition Policy (Ex post)
3. Improve Market Efficiency
Direct Incentives Subsidies, Taxation etc.
Indirect Incentives Public goods (education, basic facilities) Institutions (patents, quality certification) Input markets (capital, labor)
Privatization
Liberalization
Degree of Government Intervention
1. Public Enterprises 2. Regulation Policy 3. Direct Incentives 4. Competition Policy 5. Indirect Incentives
Transition Policies
Privatization or Nationalization
Regulation or Deregulation (Liberalization)
29
7.2. Government Intervention in Telecommunications
Possible government positions in order of decreasing intervention
1. Government ownership and central control
2. Ongoing ad hoc sector specific regulation
3. Sector specific regulation with ex ante pre-emptive intervention where deemed appropriate under the principles of competition law
4. Sector specific regulation based only on responsive ex post action under the principles of competition law
5. Reliance on general competition law
6. Self regulation within the industry
7. Withdrawal of regulation from the industry
30
8. Direct Market Control
8.1. Public Enterprises
Main scope: Altering the objective of the firm from profit maximization to social welfare maximization
Creation of public enterprises - Ideological reasons (Post-communist countries) - Political reasons (Industrial reconstruction to handle the assets
of failed private enterprises as in Greece and Italy) - Economic reasons (Public enterprises may be used to raise
government revenue)
Privatization of public enterprises - Ideological reasons (Capitalism) - Political reasons (Handle the assets of failed public enterprises) - Economic reasons (Privatization may be used to raise
government revenue)
Does state ownership always alter firm's objective?
Does ownership matter?
31
9. Control Market Efficiency
9.1. Regulation Policy
Main objective is to limit market power and increase social welfare
Regulatory instruments - Control of price
Specify a particular price Setting price within some range Specify an entire price structure
- Control of quantity Restrictions on the quantity of a product or service
- Control of the number of firms Entry and exit
- Control of other variables Minimum quality standards Investment (technology and inputs)
Regulation policy may have significant side effects in other unregulated behaviors, firms and markets
Regulatory capture: Regulators do not maximize social welfare
Regulatory costs (administrative or other implementation costs)
Regulatory Process 1. Legislation
Powers of the regulatory agency General policy objectives
2. Implementation Members of the regulatory agency Rulemaking process
3. Deregulation
32
9.2. Competition Policy
Main objective is to limit market power and increase social welfare
In practice, competition authorities are mainly concerned for consumer surplus
Main focus - Abuse of dominant position - Collusion - Mergers
Competition policy differences - Create and maintain market environments that enhance
competitive processes: Limit concentration, enhance actual or potential competition etc
- Limit firms' anticompetitive behaviors and tactics: Limit pricing, price discrimination, rationing, tacit collusion etc
- Market efficiency: Profit margins, technological innovation etc.
Competition policy process 1. Market definition 2. Market structure (shares, concentration, market power) 3. Market behavior and market efficiency
33
9.3. Regulation vs. Competition Policy
Regulation Policy
1. Monopoly or markets with a dominant firm
2. Ex ante intervention i) Government sets efficiency rules ii) Firms fulfill these rules
3. Direct effect on market efficiency
4. Specific industries
5. Focus on the abuse of dominant position
Competition Policy
1. Oligopolistic markets
2. Ex post intervention i) Firms choose their market behavior ii) Government sanctions behaviors that affect efficiency
3. Indirect effect on market efficiency
4. All industries
5. Focus on i) Abuse of dominant position ii) Collusion iii) Mergers
34
10. Efficiency of Ownership Structures
Allocative efficiency is concerned with the optimal distribution of scarce resources among individuals in the economy.
Productive efficiency is concerned with cost minimization and technological innovation in the production process.
10.1. A Simple Model
Monopoly supplying homogeneous good
Private ownership maximizes profits (shareholder wealth)
Public ownership maximizes social welfare
Managerial incentives for cost-reducing activities are imperfect
10.1.1. Private Ownership
Manager
with
q = output level
x = expenditure on cost-reducing activities
p = price
c(x) = unit cost
α = cost of effort to private manager (M) relative to the benefit to him of greater profit
assume α > 1, i.e. imperfect incentives (if a = 1 then M max profit)
10.1.2. Public Ownership
Manager
35
with
S(q,x) = consumer surplus
V(q) = consumer utility
B = cost of effort to public M relative to the benefit to him of greater social welfare
assume b > a > 1, i.e. better incentives under private ownership (imperfect public monitoring)
10.1.3. Private vs. Public
Choice of q:
- private: MR = MC, profit max
- public: V’(q) = c, socially optimal
- Allocative efficiency better under public ownership
Choice of x:
- Since a < b for given output, c private < c public
- Private ownership achieves greater productive efficiency.
If a ≥ b then,
q private < q public , p private > p public ,
x private < x public , c private > c public ,
W private < W public
and, thus, public ownership is unambiguously better.
By continuity public ownership is optimal when a < b in a neighborhood of b.
Privatization is optimal only if a is distinctly less than b (when private incentive systems are significantly better). Then the benefit
36
from greater productive efficiency outweighs the cost of reduced allocative efficiency.
10.2. Public vs. Private Ownership
Production is organized and carried out more efficiently in a privatized firm than in a public firm because better incentives can be given to managers and workers.
→ Why private ownership gives better incentives?
A public firm will choose a socially more efficient production level because the government cares about social welfare and internalizes externalities whereas a private owner just maximizes private profits.
→ Does public ownership maximizes social welfare?
10.2.1. Principal Agent Problem
Private ownership maximizes profits (shareholder wealth)
Public ownership maximizes social welfare
In both cases there is a principal agent problem to ensure that
managers act in the interests of owners
Private sector finds easier to provide incentives - managerial pay is linked to profits via stock options
- capital market discipline of take-over (publicly quoted firms)
- bank monitoring over debt
- bankruptcy
Public ownership faces difficulties in providing correct incentives - managerial pay is linked to profits (not widespread policy)
- lack hard budget constraints
37
- low ability to commit to future penalties
10.3. Social Welfare Objective
Strong assumption of benevolent government
Politicians’ key objective is reelection
Politicians care about votes and, thus, about employment
Public enterprises are inefficient because they address the objectives of politicians rather than maximize social welfare
10.3.1. A Model of Privatization and Political Control
2 players
- Politician, P
- Manager of the firm, M (M max shareholders' utility)
E = spending on labor
L efficient amount
H excess employment H>L
a = fraction of cash flows owned by M and shareholders and (1 - a) owned by treasury
P's objective function
UP = q E – m (1 – a) E
- 1st term: High E brings political benefits, but q<1
- 2nd term: High E reduces treasury's share of profits, m < 1, political costs
M's objective function
UM = - a E
38
Ownership structures
Control Right
P control M control
Cash Flow
Right
a = 0 Public Firm Corporatized Firm
a = 1 Regulated Firm Private Firm
Political Control
P chooses H iff
q H – m (1 – a) H > q L – m (1 – a) L
m (1 – a) < q (I)
P chooses excess employment when political benefits of extra spending on labor exceed political costs of foregone profits by treasury
Managerial Control
M chooses L
P may try to give subsidies to the firm not to restructure, i.e.
choose H
t = subsidy
at = effective subsidy
kat = political cost of subsidy, k < 1
Assume m < k, i.e. it is easier for P to spend firm's profits on inefficiencies than to get additional subsidies for it
Objective functions with subsidies
39
UP = q E – m (1 – a) E - kat
UM = at - aE
Incremental utilities from switching to H, ΔE = H - L
ΔUP = q ΔE – m (1 – a) ΔE - kat
ΔUM = at – a ΔE
Nash Bargaining solution
maxt [q ΔE – m (1 – a) ΔE - kat] [at – a ΔE]
t* = ((ΔE [q – m (1 – a) – ka]) / (2ka))
Given equilibrium t*, privatization leads to restructuring iff ΔUP < 0 and ΔUM < 0, i.e.
m (1 – a) + ka > q (II)
The higher is a the more likely is that (II) holds. That is why corporatization may not be enough but privatization is needed to implement restructuring
Compare (I) and (II). The difference is ka. Under privatization P must compensate M for forgone profits with subsidies at cost k per monetary unit. Under P control he does not have to compensate private sector.
In general restrictive monetary policy (high k) and privatization (high a) might be needed to assume restructuring
40
11. Methods of Privatization
1. Sales
Public sales and auctions - Maximum sale proceeds - Broad and rapid restructuring - Large impact on employment - Mitigate adverse employment impact by incorporating
contract conditions (lower proceeds and slow restructuring)
Negotiated sales to strategic investors - Enable government to achieve its social objectives - Exclude unwanted buyers - Lower selling price - Low transparency gives rise to fiscal and distributional
concerns
Management/Employee buyouts - no new capital and no new ideas - Employment, productivity, output, prices change only
gradually - Minimize impact on employment - Benefits of privatization are delayed
2. Management or lease contracts
Government retains ownership but delegates management functions
No transfer of assets to the private sector
Private technology and skills are provided
Management contract: Private company earns a fee and government keeps profits
Lease contract: Private company pays a rent and assumes full business risk
Both policies offer a steady stream of revenues for the government
Management contract: Private company has little motivation to change prices or reduce cost and employment
Lease contract: Private company has incentive to reduce cost and employment but also to raise prices
3. Mass privatization (Voucher or Coupon)
Important in transition economies
41
Shares are distributed free or at nominal cost
Does not generate revenues
Dispersed ownership (initially)
Widespread distribution of the benefits of privatization
Reselling the shares too soon creates problems and inefficiencies
4. Restitution
Return of nationalized properties to their former owners
Important in transition economies
Does not generate any revenues
Records to prove ownership are often inadequate
42
12. Regulation with Full Information
Regulator has full information about cost and demand
12.1. Single Product Monopoly
Quantity q
Demand function q = D(p) where p is the price
Cost function C(q)
Marginal Cost Pricing
p* = ∂C/∂q
- Allocative efficient
- Increasing returns to scale imply negative profits
- Need for subsidies
- No incentives to control costs
Average Cost Pricing
p* = C/q
- No subsidies
- Total revenue equals total cost
- Allocative inefficient - Welfare loss
Nonlinear Pricing
- Combination of marginal and average pricing
- Price per unit equals marginal cost
- Fixed fee is set so that total revenue equals total cost
- Efficiency losses because low demand or income consumers are
excluded
- Discriminatory two-part tariffs is a solution
43
12.2. Multi Product Monopoly
Services (or Goods) k = 1,...,n
Quantities q = (q₁,...,qn)
Demand functions qk = DK(p) where p = (p₁,...,pn) is the price vector
Elasticity of demand for service k is ηk = -[∂Dk/∂pk]/[Dk/pk]
Firm's revenue
Cost function C(q)
Gross consumer surplus S(q)
Marginal Cost Pricing
- Increasing returns to scale imply negative profits
Ramsey-Boiteux Pricing
- The Ramsey-Boiteux pricing problem consists in maximizing
subject to
or, equivalently, in maximizing
subject to
where stars refer to Ramsey-Boiteux levels.
44
- FOC with respect to qk is
- For independent demands (no cross-price effects)
- Ramsey-Boiteux prices are inversely proportional to the elasticities of demands for the services, i.e. the price structure is the same in the presence or absence of regulation
- Ramsey-Boiteux prices conforms to standard business practices
- This result holds also for interdependent demands
- Allocative inefficiency (p≠∂C/∂q) is corrected with nonlinear pricing and discriminatory two-part tariffs
45
13. Regulation with Asymmetric Information
In practice, regulators have less information about the firm's cost
Precontractual informational asymmetries - Technology, opportunity cost etc. - Government faces adverse selection problem (efficient and
inefficient firms)
Postcontractual informational asymmetries - Decisions that determine firm's production cost (not verifiable) - Government faces moral hazard problem (firm may abuse its
discretion)
46
13.1. Regulation with Money Transfers
Government instrument to solve informational problems is the payment to the firm - Adverse selection: The government must choose a payment
that will induce honest revelation of private information in order to contract with the efficient firm
- Moral Hazard: The government must choose a payment that will make the firm accountable for its realized cost in order not to abuse its discretion
Government would like to pay as little as possible - Government puts lower weight on the firm than on the other
agents in the economy
- Government puts same weight but transfers must be financed through distortionary taxation
- The firm is subject to budget balance, i.e. the firm's rent is financed through markups on the firm's services and, thus, distorts consumers' consumption and welfare
Government offers a cost reimbursement rule specifying the payment that will be made to the firm for each realization of the cost
47
13.2. Power of the incentive scheme
High powered incentive scheme: The firm bears a high fraction of its costs at the margin When the firm raises its cost by 1, its net payment is reduced by an amount close to 1 Fixed price contract
Low powered incentive scheme: The firm is not made accountable for its cost savings When the firm raises its cost by 1, the government increases its payment net payment by an amount close to 1 and so that firm's profits are hardly affected Cost plus contract
Suppose no adverse selection problem - Offering a fixed price contract gives perfect incentives to the
firm The firm fully internalizes its cost and therefore exerts socially optimal level of effort to reduce costs The government could perfectly choose the fixed price so as to leave the firm with no rent (lowest price that makes the firm willing to agree to produce)
- In the absence of adverse selection, the government would offer a high powered incentive scheme
Suppose no moral hazard problem - Offering a fixed price contract leaves excessive rents to the firm
Cost can be either 5 or 10
48
Government has no choice but offering 10 to the firm This leaves a rent equal to 5 if the firm has a low cost
- Offering a cost plus contract leaves no extra rents to the firm Suppose that the realized cost is then 8 or 13 (depending on firm's effort to reduce costs) The government could perfectly choose the payment so as to leave the firm with no rent (payment matches the cost)
- In the absence of moral hazard, the government would offer a low powered incentive scheme
There is a basic trade-off between incentives, which call for a high powered incentive scheme, and rent extraction, which requires in the presence of adverse selection, low powered incentives
49
13.3. Designing the regulatory policy under asymmetric information
Suppose that the government offers a menu of two contracts, a fixed price and a cost plus contract from which the firm selects one (or none)
The fixed price contract is designed so as to let the low cost firm just break even
The low cost firm is not tempted to choose the cost plus contract since it yields no extra gain
The high cost firm strictly prefers the cost plus contract because it would lose money under the fixed price contract
This menu of contracts allows participation by both type of firms and perfectly screens them in equilibrium (no incentive for high cost firm to reduce its costs)
It is optimal to design a menu of contracts in which the firm self selects: a high powered incentive scheme when it is efficient and a low powered incentive scheme when it is less efficient
Regulators are traditionally refrained from menu of contracts. However, they are starting to do so. - US state regulators offered regulated firms a choice between
remaining under a cost of service regime (low powered scheme) or switching to a price cap regime (high powered scheme)
- FCC designed a menu of incentive schemes for the local exchange companies relative to the provision of local access for the long distance companies
- Menu of contracts are widely used in the retail telephone services
50
13.4. Factors Limiting the Power of Incentives
13.4.1. Quality Concerns
High powered scheme: Very costly to supply quality because costs are borne entirely by the firm
Low powered scheme: Very cheap to supply quality because costs are covered by government
13.4.2. Regulatory Commitment
Ratchet effect: There is a bound on the incentives that can be provided even by formally high powered incentives - Suppose a high powered incentive contract with a given time
horizon
- An effort to reduce cost by 1 is rewarded by almost 1
- A lower cost (high effort) will convince regulator of a high firm's efficiency
- This will make regulator more demanding in the regulatory contract designed for the next regulatory review
- So while a 1 cost reduction yields 1 to the firm in the short run it also entails a penalty in the form of higher performance requirements at the next review
Renegotiation: Contract renegotiation "rewards" the firm's inefficiency and reduces the real power of incentive schemes
- Substantial firm's profits force renegotiation due to political
pressure
- Substantial firm's losses force renegotiation due to bankruptcy possibility
51
13.4.3. Regulatory Capture
Collective action problem: General public - Political representatives - Committees, Agencies etc.
Regulators are informational intermediaries, delegated monitors, supervisors (discretionary power)
Second agency problem - not sufficient incentives to collect the necessary information - not use the information in benefit of the general public
Reduction of regulatory discretion - High powered scheme are associate with high rents: Large
benefit for the firm to capture regulator in order to disclose information
- Cost plus contract eliminates firm's rent and is less sensitive to the risk of regulatory capture
Reduction of informational asymmetry between regulator and their principal - transparency (open regulatory hearings, independent appeal
procedures, written and detailed explanation of decisions etc.)
52
13.5. Regulation in Practice
13.5.1. Rate of Return Regulation
For many years, the dominant method of regulation
Main idea of this regulatory policy is to guarantee that the firm recovers its costs
Firm maximizes profits subject to a rate of return constraint
subject to
where K is capital, L is labor, w is wage rate, r is cost of capital and r is allowed rate of return.
Firm charges prices that cover its operating costs and give them a fair rate of return on the use of capital
If cost increases, the firm asks for a new set of prices
No incentive to the firm to keep its costs down
Averech-Johnson Effect: Under rate of return regulation, firms will choose too much capital relative to other inputs. Therefore, output would be produced at an inefficiently high cost
This overinvestment reduces productive efficiency but it may increase allocative efficiency
Widely used in the US
53
13.5.2. Perfect Price Cap Regulation
The firm is faced with an average price ceiling and is otherwise free to maximize its profits
The firm maximizes its profit subject to the price cap constraint, i.e.
subject to
with weights s = (s₁, ..., sn)
The price level is constrained, but not the price structure
Increases social welfare since consumers welfare is unaffected (fixed price level) and firms profits are maximized by the optimal price structure
Price cap replicates Ramsey – Boiteux pricing (inverse program)
Price cap regulation in practice: RPI - x - Widely used in the UK
The firm is required to keep the weighted increase of its prices to less than the increase in the retail price index less x percent. The x factor induces a decline in real terms to reflect technological progress.
Price control remains in place for a fixed period of four to five years
No counterincentives for cost reduction
No incentives for overinvestment in capital or other inefficient investments
Revision is less frequent, thus less problems of regulatory capture
54
14. Essential Facility and Access
Can competition on some segment be preserved when another complementary segment is monopolized?
The owner of an essential facility may have an incentive to monopolize complementary or downstream segments as well (foreclosure)
Access charges must - induce efficient use of networks - encourage their owners to invest while minimizing cost - generate an efficient amount of entry into infrastructure and
services - have reasonable regulatory cost
Difficulties for setting access charges - regulators lack the required information - lobbying and political intervention
55
14.1. The Cost Recovery Problem
c₀ marginal cost of the local loop
c₁ incumbent's marginal cost in the long distance segment
c₂ entrants' marginal cost in the long distance segment
p₁ incumbent's price for long distance services
p₂ entrants' price for long distance services
a access charge
F fixed cost
Entrants behave competitively
Incumbent
Entrant
C0 C0 C2 , p2
C1 , p1 Local Loop Local Loop
Long Distance
56
14.2. First Best Solution
The best that could be done is to follow a marginal rule: The price to the final user should be set equal to marginal cost of production
Retail prices equal marginal cost of long distance service
- Incumbent p₁ = 2c₀ + c₁
- Entrants p₂ = a + c₂ = 2c₀ + c₂
Access price equals the marginal cost of access
a = 2c₀
that is, a = direct cost
Entrants internalize the bottleneck's marginal cost
Access price is purely cost based
Entrants' profits
ΠE = p₂ - a - c₂ = 0
Incumbent's profits from the service
ΠI = p₁ - 2c₀ - c₁ = 0 incumbent's service
ΠI = a - 2c₀ = 0 entrants' service
Incumbent's total profits (including fixed network cost F)
ΠI = -F
i.e. need for lump-sum payment from the state to the incumbent to cover its fixed cost
First best can rarely be implemented in practice because the government's subsidies are not usually feasible
57
14.3. Ramsey Pricing
Need for prices, retail or wholesale, above marginal cost
Introduce markups to enable incumbent to recover its network costs
Retail prices should involve a markup above marginal cost - Incumbent
p₁ > 2c₀ + c₁
- Entrants
p₂ = a + c₂ > 2c₀ + c₂
Access price should also involve a markup above marginal cost
a > 2c₀
that is,
a = direct cost + Ramsey term
Wholesale prices should, like the incumbent's retail price, participate in the coverage of the network's fixed costs
Inefficient to set access price equal to marginal cost
Problem: Find the optimal price structure (retail and wholesale prices) that maximizes welfare (sum of producers' and consumers' surplus) given that the incumbent has to break even
maxp [CS + PS]
subject to
ΠI ≥ 0
that is exactly the Ramsey-Boiteux pricing problem
Ramsey pricing involve markups in the incumbent's access prices as well as retail prices (all the incumbent's prices should participate in the recovery of fixed costs)
58
Ramsey-Boiteux prices reflect underlying costs as well as demand characteristics (inversely proportional to the elasticities of demand)
Ramsey-Boiteux prices are at the same time cost based and usage based
Lack of necessary information to set Ramsey-Boiteux prices
59
14.4. Efficient Component Pricing Rule
Parity pricing principle or Baumol-Willig rule
Access pricing is separated from price setting in the retail market
Choose access price that maximizes welfare given the incumbent's retail prices
Retail prices are already fixed implies that access price has no effect on allocative efficiency
Focus on productive efficiency (efficient entry and cost minimization)
Regulator is not concerned with overall welfare maximization but aims at cost recovery and productive efficiency
ECPR prescribes that access price should not exceed the incumbent's costs of providing access
a ≤ p₁ - c₁
that is,
a = direct cost + opportunity cost
Costs to the incumbent when a consumer uses an entrant's service
[p₁ - (2c₀ + c₁)] + 2c₀ = p₁ - c₁
i.e. missed retail markup plus marginal cost of access
Simplicity of the formula explains its popularity
Potential entrants enter if and only if they are more efficient than the incumbent
a + c₂ ≤ p₁ ⇔
p₁ - c₁ + c₂ ≤ p₁ ⇔
c₂ ≤ c₁
60
Entry has no effect on the operating profit of the incumbent (revenue neutrality) - reduces incumbent's incentive to destroy the quality of access - if the incumbent's profits are excessive they will remain so
61
14.5. Asymmetric Information
Problems of moral hazard and adverse selection affect access charges - Regulator is unable to monitor the firms' effort to reduce costs
(moral hazard) - Regulator has less information than the firm about its
technological efficiency (adverse selection)
Fundamental trade-off between incentive provision and rent extraction
Effort is induced by fixed price contracts which make the firm residual claimant for its cost savings
Extra rents are better limited by cost plus contracts
Access price formula modifies to
a = direct cost + Ramsey term + incentive correction term
The implementation of the third term is done by offering a menu of contracts - High powered schemes should be picked by low cost producers - Low powered schemes should be picked by high cost producers
62
14.6. Dynamic Pricing Rules
Telecommunication technology is changing rapidly
Access price affects profits and hence affects - incentives to enter the market - invest in technologies - roll out new networks - maintain and upgrade existing networks
Regulators should assess these effects of access regulation on firms and market
63
14.6.1. Backward Looking Cost Based Access Pricing Rules
Access pricing rules that are based on the incumbent's actual or historical costs
Incumbent is compensated for its actual network investments
Weak incentives to reduce costs (any cost is reimbursed)
Access prices are relatively high which makes harder for entrants without network to compete
Fully Distributed Costs (FDC)
64
14.6.2. Forward Looking Access Pricing Rules
Access pricing rules that are based on currently available technology (i.e. take technological progress into account)
The general idea is to link access with the cost of the currently most efficient technology If a new network can be roll out at half the cost of the incumbent's network, then the cost of the new technology serves as the relevant benchmark
Advantages - Downward pressure on access prices - Incorporate cost efficiency (no cost is reimbursed) - Strong incentives to keep up with technological progress
Difficulties - Neglect business risks and thus may lead to underinvestment - Regulator's determination of the relevant cost benchmark is
highly discretionary - Strong incentives for anticompetitive behaviour since operators
do not make money in the access activity - High regulatory costs and scope for interest group politics
Long Run Incremental Cost (LRIC) (adopted in UK, US and advocated by the EU since 1994)
65
14.7. Global Price Cap
Usage based rather than purely cost based methods should be used to set access charges
Price Cap: The firm is faced with an average price ceiling and is otherwise free to maximize its profits
Access services, in the eyes of the operator, are just a particular type of service
Access should be treated as a final good and included in the computation of the price cap
The firm maximizes its profit subject to the price cap constraint, i.e.
maxp [TR - TC]
subject to
with weights s = (s₁,...,sn), s₀ the weight given to access services and a the access price
The firm chooses the optimal Ramsey prices without the need for the regulator to collect huge amount of information (demands, costs etc.)
Predatory practices by incumbent (raising access price and lowering other prices)
Related Documents
