Regulating Prices

If effective competition is not possible in wholesale or retail markets, it may be necessary to regulate the prices dominant firms can charge. Without price regulation, dominant firms can increase prices above competitive levels, harming their customers. This section of the toolkit covers key issues in regulating prices: The justification for ex ante price regulation why regulate prices? Economic and accounting approaches to measuring costs, Determining the structure and level of regulated prices, Benchmarking prices, Methods of price regulation, specifically rate of return regulation and incentive regulation, The relative merits of rate of return regulation versus price caps, Issues in implementing price caps, including defining the basket(s), assessing price variations, calculating the efficiency factor, and incorporating service quality and exogenous costs, and Double price caps. In addition, this section provides an overview of economic concepts that are particularly relevant to price regulation, and key pricing principles.

Contents
5.1 Why Regulate Prices? 5.2 Economic and Accounting Measures of Cost 5.3 Useful Economic Concepts 5.4 Pricing Principles for the ICT Sector 5.5 Setting the Level and Structure of Prices 5.6 Tariff Rebalancing 5.7 International Benchmarking of Prices 5.8 Rate of Return Regulation 5.9 Incentive Regulation 5.10 Rate of Return Regulation versus Price Caps 5.11 Implementing Price Caps 5.12 Towards a Double Price Cap 5.13 Price Regulation and Multiple Play Offerings

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5.1 Why Regulate Prices?

Regulation has potentially high costs. Among other things, it substitutes the regulators judgment for market interactions. No matter how capable and well intentioned regulators are, they will never be able to produce outcomes as efficient as a well-functioning market. Regulators should therefore forebear from interfering in pricing decisions unless regulation is justified. That is, unless the expected benefits from regulating prices outweigh the expected costs from doing so. This requires that, without regulation, prices will either be: Too high overall if an operator or service provider has market power they may increase prices above competitive levels. This will suppress demand for the service, leading to a loss of social welfare, or Anti-competitive an operator or service provider with market power may engage in pricing practices that hinder competition in a market. Three important anti-competitive pricing practices are cross subsidization, price squeezes, and predatory pricing. Regulatory Options If there is a case for price regulation, a number of regulatory options exist. These include: Rate of return regulation, Incentive regulation, and International benchmarking of prices. Regulatory Criteria The list below sets out common regulatory goals, which provide useful criteria for assessing regulatory options: Prevent the exercise of market power: An important goal of regulation is to ensure that prices are fair and reasonable, where competitive forces are insufficient. Any regulatory price control mechanism should encourage prices that reflect what one would observe in a competitive environment, Achieve economic efficiency: The regulatory mechanism chosen should improve economic efficiency. There are several measures of economic efficiency: o Technical efficiency (or productive efficiency) requires that goods and resources produced in the telecommunications industry should be produced at the lowest possible cost. This ensures that societys scarce resources are used efficiently and are not wasted, o Allocative efficiency requires that the prices one observes in a market are based upon and equal to the underlying costs that society incurs to produce those services (generally the long run incremental cost of producing the service). This will ensure that customers whose valuation of the service exceeds the cost of producing the service will purchase the service. Customers who place a lower valuation on the service will forgo it. This ensures that the optimal amount of the service is consumed, given cost and demand conditions. In the ICT sector prices must include some mark-up to recover shared and common costs. Markups should be set so as to minimize the impact on allocative efficiency, and o Dynamic efficiency requires that firms should have the proper incentives to invest in new technologies and deploy new services, Promote competition: Many regulators operate under a legal framework where the goal is to permit and promote competition in telecommunications markets. Where the legal framework permits competition, it is important that regulation (at a minimum) does no harm to competition, Minimize regulatory cost: All else being equal, regulators should choose a regulatory mechanism that is less costly to implement over one that is costlier to implement,

Ensure high service quality: In addition to ensuring that the prices of telecommunications services are fair, regulators are also concerned that consumers should receive a high quality service. In ranking alternative regulatory options, regulators should give preference to mechanisms that result in higher quality service, all else being equal, Ensure telephone prices are competitive with other jurisdictions: This is a relevant objective in countries, such as Singapore, that use telecommunications infrastructure as a tool for competitive advantage. In these countries, telecommunications infrastructure plays an important role in attracting foreign investment. It is therefore important that telecommunications prices are competitive with other possible destinations for foreign investment, Generate compensatory earnings: Any regulatory mechanism should provide the regulated company with the opportunity to earn a reasonable profit and to achieve compensatory earnings. If not, the firm may be forced to reduce investment and quality of service may decline.

5.2 Economic and Accounting Measures of Cost

Different cost concepts are useful for answering different questions about a firm and its activities. This section provides an overview of cost measures that are particularly relevant to price regulation: Historic costs Sunk costs Forward-looking costs Fixed costs (service specific, shared and common costs) Variable costs: marginal costs, incremental cost (including LRIC and TSLRIC) Stand-alone cost, and Short and long run cost concepts. Figure 1 shows these cost concepts relate to each other. Figure 1: Cost Concepts in Regulatory Economics

Historic cost is an accounting cost measure. The historic cost (or embedded cost) of an activity is the sum of the costs the firm actually attributes to providing that activity in a given accounting period. Historic cost reflects what a firm actually pays for capital equipment, its actual costs of operating and maintaining that equipment, and any other costs incurred to provide service during that accounting period. Sunk cost is an economic cost concept, but like accounting cost concepts, measures costs incurred in the past. Sunk costs are historic costs that are irreversibly spent and independent of the future quantity of service supplied. An example of a sunk cost is the cost of a marketing campaign for a new service. Once spent, this cost cannot be recovered regardless of whether the service continues to be provided. The economic cost of an activity is the actual forward-looking cost of that activity. This is the cost of accomplishing that activity in the most efficient way possible, given technological, geographical and other real world constraints. Forward-looking costs are the costs of present and future uses of a firms (or societys) resources. Only forward-looking costs are relevant for making pricing, production, and investment decisions in the present, or the future. Costs can be broken into the fixed costs and variable costs of providing a given service. Fixed costs do not vary as the volume of a service provided changes. For a firm that provides several services, fixed costs can be split into: Service-specific costs: Costs the firm must incur to provide a specific service. A firm supplying any level of the service would incur service-specific fixed costs, but would avoid these costs altogether by ceasing production of the service. Shared costs: Costs the firm must incur to provide a group of services. Shared fixed costs do not vary with the level of any individual service in the group, and do not vary with decisions to produce or cease producing any service or subset of services within the group. The firm can avoid shared fixed costs if it no longer provides any of the services in the group. Common costs: These are fixed costs are shared by all services produced by the firm. The cost of the presidents desk is a classic example of a fixed cost that is common to all services. Variable costs vary with the volume of service provided. Two measures of variable costs are incremental cost and marginal cost. Incremental cost is the additional cost of producing a given increment of output. How much does the firms total costs change if the volume of a particular service increases (or decreases) by a given amount? Marginal cost is the incremental cost of producing one additional unit of output. Marginal cost is a limiting case of incremental cost, where the increment is a single extra unit of service in addition to the amount currently provided. Incremental cost is usually considered over the long run long-run incremental cost (LRIC) is the cost of producing a given increment of output, including an allowance for an appropriate return on capital to reflect the costs of financing investment in facilities used for interconnection, as well as the capital costs of those facilities. Total-service long-run incremental cost (TSLRIC) is a special case of incremental cost, where the relevant increment is the total volume of the service in question, and the time perspective is the long-run. TSLRIC is the additional cost incurred by a firm when adding a new service to its existing lineup of services (holding the quantities of all those other services constant). For an existing service, TSLRIC measures the decrease in costs associated with discontinuing supply of the service entirely, other things being constant. TSLRIC is equivalent to the concept of Total element long-run incremental cost (TELRIC) used in the United States.

Stand-alone cost (SAC) is the cost that a stand-alone firm (producing no other services) would incur to produce a particular service. For a single-service firm, TSLRIC and SAC are equal. For a multiple service firm, SAC will generally be greater than TSLRIC, because SAC incorporates shared fixed costs and common fixed costs. Firms incur costs in the short run, or the long run. Short run costs are the costs of providing a given service, assuming that the current stock of capital is fixed. Over the long run, firms can vary their stock of capital, for example by investing in new plant. The long run cost of a service therefore includes the cost of the capital plant required to supply that service.

5.3 Useful Economic Concepts

This section introduces some economic concepts that are particularly relevant to the task of price setting: Economic efficiency, Economies of scale and scope, and Single and multiple-service firms. 5.3.1 Economic Efficiency and Pricing In economics, the ideal of efficient pricing is often held up as a desirable social goal. Only efficient pricing can ensure that consumers pay the true economic value of products they buy, and that societys scarce resources find their best possible uses. The following are two general principles pertaining to efficient pricing: The economically efficient price of any increment of service is the price that exactly recovers the full economic cost that will be incurred to provide that increment of service, and In a perfectly competitive market, the price of any increment of service will be driven to the full economic cost of that increment of service, and will therefore be economically efficient. Unfortunately, in practice, perfect competition very rarely (if ever) occurs. Telecommunications markets are very different from a hypothetical perfectly competitive market, as Table 1 illustrates. This means that, even where there is strong market competition, certain industries cannot follow the simple pricing rules based on the perfect competition model. When pricing services are provided by network operators, an alternative set of pricing principles apply. These are described here. In telecommunications, efficient prices typically consist of: Recovery of the variable costs of the product, plus Mark-ups to recover the products fixed costs, and any shared or common costs.

Table 1: Contrast Between Hypothetical Perfectly Competitive Firm and Real World Telecommunications Operators Perfectly Competitive Firm Real World Telecommunications Operator Single service Multiple services Service differentiated by competitor (branding, Undifferentiated service provided by all different pricing plans, packaging, customer service competitors plans, and so on) Large number of competitors. Each Fewer competitors, subject to different degrees of competitor has negligible market share and regulation and market forces. Market shares may not no control over price be negligible No economies of scale or scope No regulation, no franchise obligations Economies of scale and scope prevalent. High fixed costs, often high sunk costs Varying degrees or terms of regulation. Franchise obligations common (universal service, carrier of last resort, below-cost pricing of local service)

No restrictions on capital. Depreciation Depreciation rates and cost of capital often below determined purely by technological economic levels (subject to regulatory approval) and and economic conditions (including risk) may not reflect prospective market risks Undifferentiated and perfectly informed Customer base with widely varying demand and usage customers characteristics 5.3.2 Economies of Scale and Scope The production process for telecommunications operators is characterized by economies of scale and scope. This is because telecommunications operators generally have high fixed costs and high shared and common costs. Economies of scale occur when a firms average cost decreases when it increases its volume of production. For example, economies of scale occur where a firm has high fixed costs of production. By increasing production, the firm can reduce its average cost per unit of output. (Provided that variable costs are relatively low, and/or do not increase quickly as production increases.) Economies of scope occur when some of the fixed resources needed to produce one service can, at no extra cost, be shared to produce another service. In this situation, it is more economical to produce the two services together and pay only once for the shared resources, than to produce the services separately. The practical significance of economies of scope and scale is that telecommunications operators with significant fixed costs can actually experience lower costs per unit by sharing resources and becoming a provider of multiple services. Operators that start out by providing only one service may benefit by diversifying and providing multiple services. Customers also benefit because economies of scope translate into lower prices than under standalone production. By sharing resources the operator only pays once for the resources concerned. As a result the total cost of providing all of the operators services is lower.

5.3.3 Single- and Multiple-Service Firms A single-service firm is a firm that provides only one service to customers. A multiple-service firm is a firm that provides several services to customers. In a single-service firm there are no shared or common costs, and no need to attribute costs between services in order to calculate prices. As Figure 1 shows, the services stand-alone cost is equal to the total cost of the firm. Cost and price calculations are considerably more complex for a multiple-service firm. Some of the firms costs will be shared by groups of services, or common to all services provided by the firm. For a multiple-service firm, total cost is the aggregation of the TSLRICs of the individual services, the costs shared by various combinations of services and the costs that are common to all services (see Figure 1). Shared and common costs cannot be directly attributed to individual services, but must still be somehow recovered through prices. Figure 1: Cost Structure of a Single- Versus a Multiple-Service Firm

5.4 Setting the Level and Structure of Prices

This section discusses the task of setting prices for network operators and service providers. Click on the links below for information on: The relationship between fixed and variable costs and efficient prices, Methods for determining mark-ups over TSLRIC, and Tariff rebalancing. Pricing refers to the task of setting either a single price for an increment of service, or of determining a range within which that price should fall. This means determining both the minimum acceptable price (the price floor) and the maximum acceptable price (the price ceiling). The price for an increment of service should be set based on forward-looking costs. That is because the prime consideration in pricing is the value of the resources that will be used to produce the increment of service, specifically: The mix of technologies needed to produce the increment of service, The prices of input resources, and The future economic depreciation rates and cost of capital that will apply. In other words, the price for an increment of service must at least cover the incremental cost of that increment. The incremental cost of the service determines the minimum acceptable price for the service. In order to determine a range of reasonable (and subsidy free) prices, regulators must also identify the maximum acceptable price. This is usually the stand alone cost of the relevant increment of service. With free entry into the industry, no supplier could charge a price higher than the stand alone cost without encouraging other suppliers to enter the market. (Note that, if the firm has no shared or common fixed costs, the incremental cost will be equal to the stand alone cost.)

In practice, it is very difficult to reliably estimate the stand alone cost of services provided by a multiple-service firm, such as a telecommunications operator. However, it is possible to determine whether a multiple-service firm is charging more than the maximum acceptable prices for one or more of its services, using incremental cost information. The rule for ensuring that prices for all of a firms services do not exceed stand alone costs is: Provided that the firm just breaks even, the price of every service it provides must be no lower than the TSLRIC of that service. A network operator cannot recover its total costs if it prices all of its services at exactly their respective TSLRICs. In order to recover legitimate total costs network operators must mark up their prices above TSLRIC. Fixed and Variable Costs and Price Setting efficient prices typically consist of: Recovery of the variable (or incremental) costs for the product, A mark-up to recover that products fixed costs, An additional mark-up to recover any costs shared with other products, Another mark-up to recover the firms common costs. The mark-ups to recover fixed, shared, and common costs do not need to be uniform amounts or percentages. Mark-ups can vary, provided that: Total revenues for each product are sufficient to recover all variable and fixed costs for that product, Total revenues for a family of products with shared costs are sufficient to recover all product-specific fixed and variable costs for each service, plus the shared costs for that family, and Total revenues for the firm are sufficient to recover the firms total costs. Figure 1, below, illustrates the relevance of different types of cost for price setting. In producing the total volume of a product, for example Product A in Figure 1, a firm may incur costs that are specific to that product. Prices should generate sufficient revenues for that product to recover all variable and product-specific fixed costs. If the firm charges a single price for all units of Product A, that price should include a mark-up above the variable (or incremental) costs, to cover any fixed costs that are specific to Product A. Some products may share costs (for example Products A, B, and C in Figure 1). In this case, economically efficient prices for these products need to also include a mark up to cover the shared costs for that family of services. Finally, prices for all services need to be high enough to recover the common costs of the firm. Figure 1: Example of Costs of a Multiproduct Firm

5.5 International Benchmarking of Prices

International benchmarking the process of establishing the price of a service based on prices in other jurisdictions. Benchmarking can be used as a common sense check on the results of cost models. Alternatively, it can be used directly to set prices. For example in Singapore, the price SingTel can charge is based on the prices of telephone services in neighbouring Asian countries, New York, and London. Benchmarking involves: Selecting a sample of countries or operators. Countries used in the benchmark should be at similar stages of socio-economic and industry development as the country whose interconnection rates are being considered, Gathering price data for the service(s) under consideration in each of the sample countries, and Adjusting benchmarked rates to account for differences between the country being regulated and the benchmark countries. Practical Issues in Benchmarking Interconnection Rates Without appropriate adjustments, benchmarking can result in interconnection rates that make little sense. The goal of the adjustments is to try to model interconnection costs without having enough detailed information on local cost inputs to carry out a full forward-looking cost analysis. Adjustments are often made for: Population density: The number of inhabitants per square kilometre in each country can affect network development costs. Countries with high population densities tend to have lower network costs than countries with lower population densities, Local area size: This may affect the proportion of short and long distance calls and therefore the costs of interconnection, Extent of urbanization: Network development costs are lower for urban areas than rural areas. Countries with a high degree of urbanization tend to have lower network costs than countries with less urbanization, Call duration: This may vary widely across countries for several reasons. For example, if customers pay a flat rate for unlimited local calling, average call duration is likely to be longer than in countries where customers pay a per-minute rate. Networks with higher call durations need more network capacity, and so will have higher costs, Input prices: The costs of key inputs will vary across countries, and this will affect interconnection costs. For example, the cost of capital will be significantly higher for most developing countries than for developed countries, due to higher risk in developing markets, Scale economies: If a firm faces significant fixed costs, average cost is likely to decline as output increases. Markets with greater scale generally have lower average costs. When attempting to extrapolate prices or costs from countries with scale advantages to a country with a smaller market, it may be necessary to adjust the benchmarked data, Exchange rates: Rates need to be converted to the local currency, or some other single monetary unit. This conversion can use either market exchange rates or purchasing power parity (PPP) exchange rates. It makes sense to use PPP exchange rates when the majority of the regulated firms costs are local currency denominated and locally sourced, such as staff costs. If the firms costs largely consist of repaying foreign currency denominated loans and purchasing capital equipment on the international market, then market exchange rates are generally more appropriate as a basis for comparing prices and costs. When using PPP exchange rates, it is best to use rates estimated by recognized international institutions such as the World Bank, International Monetary Fund or OECD, Taxes: Price data included in the exercise should either all include, or all exclude retail taxes,

Rounding effects: If tariffs are being compared based on a unit of time, the rounding effects of billing mechanisms have to be taken into account. For example, if calls in one country are billed by the minute, and in another country by the second, charges must be converted to a single unit (either per minute or per second) to allow a meaningful comparison.

5.6 Rate of Return Regulation

This section covers the following topics: An overview of rate of return regulation, Calculating the revenue requirement for regulated services, and Setting prices for regulated services. Overview of Rate of Return Regulation Rate of return regulation is a way of regulating the prices charged by a firm. It restricts the amount of profit (return) that the regulated firm can earn. Rate of return regulation has been used extensively to regulate utilities in many countries. It has been used in the United States since public utility regulation began in the early 1900s. There are two steps to implementing rate of return regulation: First, determine the economically appropriate revenue requirement. This is based on prudently incurred expenses and a fair return on invested capital, and Second, set prices for individual services so revenue earned from all the regulated services is not greater than the revenue requirement.

5.7 Price Regulation and Multiple Play Offerings

Significant questions about the applicability of price regulation arise with the advent of intermodal competition, that is, competition between, say, traditional telephone networks and cable television providers whereby each provider offers voice telephony, broadband data, and video content services. This particular offering is popularly described as a Triple Play. The addition of mobile services offers the possibility of a fourth play in the mixture. Each provider uses a different network infrastructure. Generally, cable television providers seem to be having an easier time upgrading their networks so as to offer broadband data and voice telephony than traditional telephone providers are having in adding video content services to their offerings. Still, multiple play offerings are becoming more and more widespread throughout the world. The rationales described in section 5.1 whereby price regulation has been applied to a telecommunications provider are weakened considerably when that provider faces competition from a competing infrastructure. Regulation is, after all, intended as a substitute for competition and where competition itself exists or is emerging, the justification for continuing to regulate retail prices becomes less relevant. Some regulators are responding to the emergence of intermodal competition by exempting multiple play offerings from price cap regulation. The traditional voice telephony service is still available to be purchased at a regulated price, but the regulator has opted to allow the market to determine the price for the bundled triple play offering. However, this is an emerging area and the policy questions are evolving rapidly.