Regulating Prices

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Regulating Prices

If effective competition is not possible in wholesale or retail markets, it may be necessary toregulate the prices dominant firms can charge. Without price regulation, dominant firms canincrease prices above competitive levels, harming their customers.This section of the toolkit covers key issues in regulating prices:

The justification for ex anteprice regulation why regulate prices? Economic and accounting approaches tomeasuring costs, Determining thestructure and level of regulated prices, Benchmarking prices, Methods of price regulation, specifically rate of return regulation and incentive

regulation, The relative merits ofrate of return regulationversusprice caps, Issues in implementing price caps, including defining the basket(s), assessing price

variations, calculating the efficiency factor, and incorporating service quality andexogenous costs, and

Double price caps.In addition, this section provides an overview ofeconomic conceptsthat are particularly relevantto price regulation, and keypricing principles.

Contents5.1 Why Regulate Prices?5.2 Economic and Accounting Measures of Cost5.3 Useful Economic Concepts5.4 Pricing Principles for the ICT Sector5.5 Setting the Level and Structure of Prices5.6 Tariff Rebalancing

5.7 International Benchmarking of Prices5.8 Rate of Return Regulation5.9 Incentive Regulation5.10 Rate of Return Regulation versus Price Caps5.11 Implementing Price Caps5.12 Towards a Double Price Cap5.13 Price Regulation and Multiple Play Offerings

http://www.ictregulationtoolkit.org/en/Section.1639.html


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5.1 Why Regulate Prices?Regulation has potentially high costs. Among other things, it substitutes the regulatorsjudgment 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 isjustified. That is, unless the expected benefits from regulating prices outweigh the expected costsfrom doing so. This requires that, without regulation, prices will either be:

Too high overall if an operator or service provider has market power they mayincrease 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 inpricing practices that hinder competition in a market. Three important anti-competitivepricing practices arecross subsidization, price squeezes, andpredatory pricing.

Regulatory OptionsIf 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 CriteriaThe list below sets out common regulatory goals, which provide useful criteria for assessingregulatory options:

Prevent the exercise of market power: An important goal of regulation is to ensure thatprices are fair and reasonable, where competitive forces are insufficient. Any regulatoryprice control mechanism should encourage prices that reflect what one would observe ina competitive environment,

Achieve economic efficiency: The regulatory mechanism chosen should improveeconomic efficiency. There are several measures of economic efficiency:

o Technical efficiency (or productive efficiency) requires that goods andresources produced in the telecommunications industry should be produced at the

lowest possible cost. This ensures that societys scarce resources are usedefficiently and are not wasted,

o Allocative efficiency requires that the prices one observes in a market are basedupon and equal to the underlying costs that society incurs to produce thoseservices (generally the long run incremental cost of producing the service). Thiswill ensure that customers whose valuation of the service exceeds the cost ofproducing the service will purchase the service. Customers who place a lowervaluation on the service will forgo it. This ensures that the optimal amount ofthe service is consumed, given cost and demand conditions. In the ICT sectorprices must include some mark-up to recover shared and common costs. Mark-upsshould be set so as to minimize the impact on allocative efficiency, and

o Dynamic efficiency requires that firms should have the proper incentives toinvest in new technologies and deploy new services,

Promote competition: Many regulators operate under a legal framework where the goalis to permit and promote competition in telecommunications markets. Where the legalframework permits competition, it is important that regulation (at a minimum) does noharm to competition,

Minimize regulatory cost: All else being equal, regulators should choose a regulatorymechanism that is less costly to implement over one that is costlier to implement,


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Ensure high service quality: In addition to ensuring that the prices oftelecommunications services are fair, regulators are also concerned that consumersshould receive a high quality service. In ranking alternative regulatory options,regulators should give preference to mechanisms that result in higher quality service, allelse being equal,

Ensure telephone prices are competitive with other jurisdictions: This is a relevantobjective in countries, such as Singapore, that use telecommunications infrastructure as a

tool for competitive advantage. In these countries, telecommunications infrastructureplays an important role in attracting foreign investment. It is therefore important thattelecommunications prices are competitive with other possible destinations for foreigninvestment,

Generate compensatory earnings: Any regulatory mechanism should provide theregulated company with the opportunity to earn a reasonable profit and to achievecompensatory earnings. If not, the firm may be forced to reduce investment and qualityof service may decline.

5.2 Economic and Accounting Measures of CostDifferent cost concepts are useful for answering different questions about a firm and itsactivities. This section provides an overview of cost measures that are particularly relevant toprice 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 runcost concepts.

Figure 1 shows these cost concepts relate to each other.

Figure 1: Cost Concepts in Regulatory Economics


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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 ofthe future quantity of service supplied. An example of a sunk cost is the cost of a marketingcampaign for a new service. Once spent, this cost cannot be recovered regardless of whether theservice continues to be provided.Theeconomic cost of an activity is the actual forward-looking cost of that activity. This is thecost 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 andfuture uses of a firms (or societys) resources. Only forward-looking costs are relevant formaking pricing, production, and investment decisions in the present, or the future.Costs can be broken into the fixed costsandvariable costsof 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 wouldavoid these costs altogether by ceasing production of the service.

Shared costs: Costs the firm must incur to provide a group of services. Shared fixedcosts do not vary with the level of any individual service in the group, and do not varywith decisions to produce or cease producing any service or subset of services within thegroup. The firm can avoid shared fixed costs if it no longer provides any of the servicesin 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 areincremental cost and marginal cost.Incremental cost is the additional cost of producing a given increment of output. How muchdoes the firms total costs change if the volume of a particular service increases (or decreases) bya given amount?Marginal cost is the incremental cost of producing one additional unit of output. Marginal costis a limiting case of incremental cost, where the increment is a single extra unit of service inaddition 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, wherethe relevant increment is the total volume of the service in question, and the time perspective isthe long-run. TSLRIC is the additional cost incurred by a firm when adding a new service to itsexisting lineup of services (holding the quantities of all those other services constant). For anexisting service, TSLRIC measures the decrease in costs associated with discontinuing supply ofthe service entirely, other things being constant. TSLRIC is equivalent to the concept ofTotalelement long-run incremental cost (TELRIC) used in the United States.


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Stand-alone cost (SAC) is the cost that a stand-alone firm (producing no other services) wouldincur to produce a particular service. For a single-service firm, TSLRIC and SAC are equal. Fora multiple service firm, SAC will generally be greater than TSLRIC, because SAC incorporatesshared 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 agiven service, assuming that the current stock of capital is fixed. Over the long run, firms canvary 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 ConceptsThis section introduces some economic concepts that are particularly relevant to the task of pricesetting:

Economic efficiency, Economies of scale and scope, and Single and multiple-service firms.

5.3.1 Economic Efficiency and PricingIn 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 exactlyrecovers 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 tothe full economic cost of that increment of service, and will therefore be economicallyefficient.

Unfortunately, in practice, perfect competition very rarely (if ever) occurs. Telecommunicationsmarkets 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 followthe simple pricing rules based on the perfect competition model. When pricing servicesare provided by network operators, an alternative set of pricing principles apply. These aredescribed 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.


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Table 1: Contrast Between Hypothetical Perfectly Competitive Firm and Real WorldTelecommunications Operators

Perfectly Competitive Firm Real World Telecommunications Operator

Single service Multiple services

Undifferentiated service provided by allcompetitors

Service differentiated by competitor (branding,different pricing plans, packaging, customer service

plans, and so on)Large number of competitors. Eachcompetitor has negligible market share andno control over price

Fewer competitors, subject to different degrees ofregulation and market forces. Market shares may notbe negligible

No economies of scale or scopeEconomies of scale and scope prevalent. High fixedcosts, often high sunk costs

No regulation, no franchise obligationsVarying degrees or terms of regulation. Franchiseobligations common (universal service, carrier of lastresort, below-cost pricing of local service)

No restrictions on capital. Depreciation

determined purely by technologicaland economic conditions (including risk)

Depreciation rates and cost of capital often below

economic levels (subject to regulatory approval) andmay not reflect prospective market risks

Undifferentiated and perfectly informedcustomers

Customer base with widely varying demand and usagecharacteristics

5.3.2 Economies of Scale and ScopeThe production process for telecommunications operators is characterized by economies of scaleand scope. This is because telecommunications operators generally have high fixed costs andhighsharedandcommoncosts.Economies of scaleoccur 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. Byincreasing production, the firm can reduce its average cost per unit of output. (Provided thatvariable costs are relatively low, and/or do not increase quickly as production increases.)Economies of scopeoccur 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 toproduce the two services together and pay only once for the shared resources, than to produce theservices separately.The practical significance of economies of scope and scale is that telecommunications operatorswith significant fixed costs can actually experience lower costs per unit by sharing resources andbecoming 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 stand-alone 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.


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5.3.3 Single- and Multiple-Service FirmsA single-service firm is a firm that provides only one service to customers. A multiple-servicefirm 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 costsbetween services in order to calculate prices. As Figure 1 shows, the services stand-alonecost 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 thefirm. For a multiple-service firm, total cost is the aggregation of the TSLRICs of the individualservices, the costs shared by various combinations of services and the costs that are common toall services (see Figure 1). Shared and common costs cannot be directly attributed to individualservices, but must still be somehow recovered through prices.

Figure 1: Cost Structure of a Single- Versusa Multiple-Service Firm

5.4 Setting the Level and Structure of PricesThis section discusses the task of setting prices for network operators and service providers.Click on the links below for information on:

The relationship betweenfixed and variable costs and efficient prices, Methods for determiningmark-ups over TSLRIC, and Tariff rebalancing.

Pricing refers to the task of setting either a single price for an increment of service, or ofdetermining a range within which that price should fall. This means determining both theminimum 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 isbecause the prime consideration in pricing is the value of the resources that will be used toproduce the increment of service, specifically:

The mix of technologies needed to produce the increment of service, The prices of input resources, and The future economicdepreciationrates and cost of capital that will apply.

In other words, the price for an increment of service must at least cover the incremental cost ofthat increment. The incremental cost of the service determines the minimum acceptable price forthe service.In order to determine a range of reasonable (and subsidy free) prices, regulators must alsoidentify the maximum acceptable price. This is usually the stand alone cost of the relevantincrement of service. With free entry into the industry, no supplier could charge a price higherthan the stand alone cost without encouraging other suppliers to enter the market. (Note that, ifthe firm has no shared or common fixed costs, the incremental cost will be equal to the standalone cost.)


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In practice, it is very difficult to reliably estimate the stand alone cost of services provided by amultiple-service firm, such as a telecommunications operator. However, it is possible todetermine whether amultiple-service firmis charging more than the maximum acceptable pricesfor one or more of its services, using incremental cost information. The rule for ensuring thatprices 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 lowerthan the TSLRIC of that service.

A network operator cannot recover its total costs if it prices all of its services at exactly theirrespectiveTSLRICs. In order to recover legitimate total costs network operators must mark uptheir 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 orpercentages. Mark-ups can vary, provided that:

Total revenues for each product are sufficient to recover all variable and fixed costs forthat product,

Total revenues for a family of products with shared costs are sufficient to recover allproduct-specific fixed and variable costs for each service, plus the shared costs for thatfamily, 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 incurcosts that are specific to that product. Prices should generate sufficient revenues for that productto 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-upabove 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 theshared 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


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5.5 International Benchmarking of PricesInternational benchmarkingthe process of establishing the price of a service based on prices inother jurisdictions. Benchmarking can be used as a common sense check on the results of costmodels. Alternatively, it can be used directly to set prices.For example in Singapore, the price SingTel can charge is based on the prices of telephoneservices in neighbouring Asian countries, New York, and London.Benchmarking involves:

Selecting a sample of countries or operators. Countries used in the benchmark should beat similar stages of socio-economic and industry development as the country whoseinterconnection rates are being considered,

Gathering price data for the service(s) under consideration in each of the samplecountries, and

Adjusting benchmarked rates to account for differences between the country beingregulated and the benchmark countries.

Practical Issues in Benchmarking Interconnection RatesWithout appropriate adjustments, benchmarking can result in interconnection rates that makelittle sense. The goal of the adjustments is to try to model interconnection costs without havingenough 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 havelower network costs than countries with lower population densities,

Local area size: This may affect the proportion of short and long distance calls andtherefore the costs of interconnection,

Extent of urbanization: Network development costs are lower for urban areas than ruralareas. Countries with a high degree of urbanization tend to have lower network costs thancountries 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 highercall 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 affectinterconnection costs. For example, the cost of capital will be significantly higher formost developing countries than for developed countries, due to higher risk in developingmarkets,

Scale economies: If a firm faces significant fixed costs, average cost is likely to declineas output increases. Markets with greater scale generally have lower average costs. Whenattempting to extrapolate prices or costs from countries with scale advantages to acountry 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 singlemonetary unit. This conversion can use either market exchange rates or purchasing powerparity (PPP) exchange rates. It makes sense to use PPP exchange rates when the majorityof the regulated firms costs are local currency denominated and locally sourced, such asstaff costs. If the firms costs largely consist of repaying foreign currency denominatedloans and purchasing capital equipment on the international market, then marketexchange 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 recognizedinternational 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 retailtaxes,


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

5.6 Rate of Return RegulationThis section covers the following topics: Anoverviewof rate of return regulation, Calculating therevenue requirementfor regulated services, and Setting pricesfor regulated services.

Overview of Rate of Return RegulationRate of return regulation is a way of regulating the prices charged by a firm. It restricts theamount of profit (return) that the regulated firm can earn. Rate of return regulation has been usedextensively to regulate utilities in many countries. It has been used in the United States sincepublic 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 OfferingsSignificant questions about the applicability of price regulation arise with the advent ofintermodal competition, that is, competition between, say, traditional telephone networks andcable television providers whereby each provider offers voice telephony, broadband data, and

video content services. This particular offering is popularly described as a Triple Play. Theaddition of mobile services offers the possibility of a fourth play in the mixture. Each provideruses a different network infrastructure. Generally, cable television providers seem to be havingan easier time upgrading their networks so as to offer broadband data and voice telephony thantraditional 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 atelecommunications provider are weakened considerably when that provider faces competitionfrom a competing infrastructure. Regulation is, after all, intended as a substitute for competitionand where competition itself exists or is emerging, the justification for continuing to regulateretail prices becomes less relevant. Some regulators are responding to the emergence ofintermodal competition by exempting multiple play offerings from price cap regulation. Thetraditional voice telephony service is still available to be purchased at a regulated price, but theregulator has opted to allow the market to determine the price for the bundled triple playoffering. However, this is an emerging area and the policy questions are evolving rapidly.

Regulating Prices

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