Riassunto Markets, Regulations and Law

Markets, regulation & law

Ramsey pricing vs. peak load pricing

There are different pricing schemes for the multi-product regulated firms. These schemes have shared the "common cost problem", which affirms: the calculation of the average cost of a basket of products can be computed by dividing the total fixed costs of the company by the number of units produced. The problem can be solved with the "Allais rules": considering the common costs and the marginal costs for each unit, the company can compute the mark-up in a way to gain sufficient revenues to cover the costs. So, the division of the common cost can be useful to calculate the mark-up. By the way, not all the schemes need the allocation of common costs. The main two examples are the "Peak load pricing" and the "Ramsey pricing".

The first can be used when there are goods not easy to sell in different periods of the year and a company is constrained to choose a single capacity level; in this case, the regulatory mechanism is appropriate. Formulating price for different time periods is related to the common cost problem: the optimal price depends on how much of the capacity is allocated in each period. The formula for computing the total cost is ‘bsom.ydit più betamaxydit’. Meaning that the total cost is equal to the cost of the variable input times the total amount of the variable input used in all the periods plus the rental cost of capital times the maximum output produced in any period. Knowing that the social optimum is reached when the marginal costs are equal to the price in any period, we can affirm that in every non-peak period the price is optimally set if it's equal to the variable input b; in the peak period the price will be equal to the capacity cost plus the price of the variable input. To sum up: during the peak period the consumers are responsible for the variable costs and the capacity cost and this method permits not only to reach a social optimum situation but also allows the firm to earn sufficient money to cover the costs. There are also some problems with the peak-load pricing: the method is not robust to technological changes and the existence of uncertainty over demand or supply can complicate its application.

About the Ramsey pricing, it can be used to satisfy the necessity to cover costs with revenues when a company can set a single price for each good produced. In these cases, the maximization problem could be solved with the following formula: CS(y) + py – C (y,w), where CS(y) represents the consumer surplus as a function of the entire output vector y; p (the price vector) is multiplied with the number of goods produced; C(y,w) is the total cost as a function of the output and input price. Then, to solve the maximization problem, it's necessary to understand the following relationship: (pdiixCdiyi)/pixediijx(pdiixCdiyi)/pdiixeijjxi,j; where it is shown the marginal costs and the price referred to the product i and the elasticity represented with ediij. This relationship shows that the optimal prices are such that the "price cost" margin multiplied by the elasticity of the demand be equal across all products produced by the firm. On the other hand, the price of inelastic goods will be higher than the price of elastic ones. To sum up again, the discrimination of the price could be made in two different ways: for product or for customers. The finality of this discrimination is to cover the cost of products, setting a higher price for the product with an inelastic demand and a lower one for goods with a more elastic demand to cover the costs. With the customers, this discrimination could be made with a geographic discrimination: a higher price for the nation with richer citizens and a lower price for the nation with poorer citizens.

Essential facility doctrine

The essential facility cases involve the refusal of one firm to provide other firms access to something vitally important to compete in the market. It can happen when a firm is dominant and vertically integrated and refuses to deal with a competitor in a downstream market. This doctrine was developed in the US starting from 1912, strictly related to the markets' liberalization. Trying to find what facilities were essential, the court at that time reunited a flood of litigation involving access to disparate facilities. The most important case in the recent era has been the case "MCI Comms. VS. AT&T": in this case, the MCI wanted to interconnect with the AT&T phone in a way to compete in the long-distance telephone market. The court established that the essential facilities for MCI were: the feasibility of providing the facility, the denial of the use of the facility to a competitor; the control of the essential facility by a monopolist and the inability of competitors to duplicate the essential facility. Some observations can be made: Competition law protects competition, not competitors -- this doctrine will bring an unsatisfactory result because it will let the competitors reach their more efficient counterparts and, the application of the law, will discourage them to innovate; Granting access through essential facilities should be limited to natural monopolies -- in other industries, the application of the essential facilities doctrine will undermine the incentives for efficiency and innovation activities by the dominant firm, which may be discouraged since the company's efforts would be diminished; Sharing a facility for a company is not always a good idea -- because consumers are not better off when a monopoly is shared and the right of sharing a monopoly discourages firms from developing alternative inputs.

This is the reason why, according to the US mainstream, the essential facilities doctrine is both harmful and unnecessary and should be abandoned. That’s why according to the US Supreme Court in Trinko, innovation is stimulated by the hope of gaining a competitive advantage. The opportunity to charge monopoly prices is what attracts business sharpness; it induces risk-taking that produces innovation and economic growth. To safeguard the incentive to innovate, the possession of monopoly power will not be found unlawful unless it is accompanied by an element of anti-competitive conduct. Concluding, we can say that the monopoly is not a bad practice; it is the prize for the winner (the most innovative company). On the other hand, the EU has been much less skeptical than mainstream US courts in recognizing an essential facility doctrine, under the rubric of abuse of dominant position. It did not hesitate to apply such a doctrine even to IPRs. Four factors are sufficient to trigger a violation based on refusal to deal: it’s unjustified; it excludes competition on a secondary market; access to the facility is indispensable to carry on a business in the market; the refusal doesn’t permit the emergence of a new product for which there’s a demand from customers.

Efficient component pricing rule (Baumol-Willig rule)

The rule states that access to essential facilities should be priced at the direct cost of providing access plus the opportunity cost to the regulated firm of granting access to a competitor. Potential benefits of the rule are: leading to efficient entry since no firm will enter the competitive market unless its marginal cost is less than or equal to the marginal cost of the incumbent regulated firm; including the regulated firm’s opportunity cost in the access charge, subsidies mandated by regulators can be maintained.

Critics: it’s not a general rule because its efficiency result is contingent on a number of strict assumptions, it gives the efficient solution to pricing access subject to the assumption that the price of the final product is subject to effective regulation or effective competition. Laffont and Tirole identify the following assumptions as necessary to ensure the efficiency of the rule: the regulated firm’s price for the final product is based on marginal-cost pricing; the products produced by the regulated firm and the entrant are perfect substitutes; production of the final product is characterized by constant returns to scale; the entrant has no market power; and the regulated firm’s marginal cost can be accurately observed. If any of these doesn’t hold, the access price must be adjusted from the rule level to achieve efficiency.

Benchmark competition

Yardstick competition, or Benchmark competition, consists in setting the price a regulated firm receives depending on the costs of identical firms. The latter constitute a benchmark against which the potential utility can be assessed. Costs are private information, so the regulator uses that info only when regulating other utilities, not for regulating the utilities whose costs info has been disclosed. Since the info provided will not influence the providers, the firms who disclose them have no incentive to give false information. It is assumed that firms maximize profits, but as long as they’re not at stake, they won’t invest to reduce costs.

Critics: benchmark competition is exposed to collusion, since profits depend on the information disclosed; it might be compromised when single monopolistic utilities have been split up into a number of privatized utilities.

Price cap vs rate of return: differences, pros and cons

Rate of return is a regime of cost-plus pricing through which the regulatory agency sets prices in a way that the utility covers the cost of production and earns a fair rate-of-return on its investment. It seems a simple form of regulation, but: firms have no incentive to operate efficiently and minimize costs; firms may have an incentive to over-invest in capital equipment, the more they invest the greater their excess return (Averch-Johnson effect). A firm that is expanding capacity will construct the new plant, and only once the construction is completed will the rate base change. If the new capital was automatically added to the rate base, then firms may have the incentive to invest in plants that are bigger than necessary in order to inflate the rate base and increase profits.

With the price-cap the regulator sets a cap for a specified period (3-5 years), that the firm can charge for a defined basket of goods and services. In order to take account of rates of inflation, the regime allows firms to vary its price in any year by an amount that is linked to the overall level of inflation; a price-cap permits a utility to increase its level of prices by the previous year’s rate of inflation, as measured by the retail price index, which is then varied by a percentage that reflects the real cost reduction that the regulator expects. Price-cap is an incentive regulation, any cost savings is, at least in part, retained by the firm, reinstating the incentive of the firm to minimize cost. There are additional benefits: it reduces regulatory administrative costs; the regulated market is decoupled from other markets, eliminating the inefficient incentives firms subject to rate-of-return regulation face in regard to entering markets in which they are not competitive; it requires less information regarding technological change to implement. Price-cap regulation is based on incentives to cut costs: if prices are set for a period in advance, the firm has an incentive to become more efficient, as it keeps the difference between the predetermined price and its actual costs. In calibrating the cap the regulator will try to achieve a balance between costs and revenues over the specified period as a whole; while under the rate of return regulation the firm can recover whatever costs it has historically incurred, with a price-cap the regulator is making a projection of costs into the future, and setting overall prices so that they will cover those expected costs. However, the price-cap set for the next period will take account of the level of profits that the firm is earning, so if the regulator believes that excess profits are being earned, it will adjust prices in the subsequent period accordingly, either by a once-and-for-all adjustment to bring prices back into line with costs or by a gradual process of elimination of excess profits over the next period.

Problems: The determination of the caps and the frequency with which they are adjusted. The shorter the interval between the setting of the price caps, the closer RPI-X is to rate-of-return regulation. This is because, when reviewing the value of X, the regulator’s perception of the scope for performance improvements is influenced by how well the incumbent has done in the recent past as indicated by its rate of profit. A further problem arises when excessive profitability leads to unanticipated changes in the value of X since these changes may weaken the incentives that price cap regulation is supposed to instill and be detrimental for both investment and entry in the industry; An inappropriate design of price caps may fail to prevent cross-subsidization. This may happen when firms are selling some goods or services in potentially competitive markets where the incumbent firm can bundle competitive services with monopoly services and has an incentive to set prices to the detriment of competition. So, it is important to determine a suitable composition of the basket of goods and services that are subject to the price cap.

General issues and examples

Regardless of the form of price regulation, asymmetric information inevitably leads to regulators being poorly informed relative to those they regulate and provides incentives for strategic behavior on the part of regulated firms; Difficulties in controlling quality of service.

Examples:

• Not regulated monopolist: in pricing output of a given quality, its route to profit maximization is clear, raise prices up to where any further increase will reduce demand so much as to lower profits. When quality is a choice variable, it will either under-supply or over-supply quality; the monopolist chooses the quality level with an eye to the preference of the consumer that at the price charged, is on the margin of buying or not the product.
• Rate of return regulation: consumers are likely to benefit chiefly because price of output of a given quality is controlled; in addition, the quality of output may rise if rate of return encourages capital intensity.
• Price-cap regulation in action: the regulated firm with a given price cap will be able to make extra profits by degrading the quality of the service, this is a means of evading the price cap. Where the quality of service can be differentiated across customers, the solution is to offer them a choice of tiered levels of service, and to pay compensation for failure to deliver these as due to individual customers. Where the quality attribute is public, the solution is to incorporate quality measurements into the price-cap formula.

Antitrust analysis of two-sided market

Multi-side markets are platforms that bring together two or more groups of consumers, which need each other, but cannot capture the value from their mutual attraction on their own. They rely on the platform to facilitate the value-creating interactions between them. In platforms’ business models, the value is created by the users, not by the supplier of the service. EU Commission suggests online platforms facilitate interactions; have big data aggregation capacities; can shape new markets and disrupt traditional ones; they rely on information technology as the means to achieve all of the above. Two indirect externalities: usage externalities, membership externalities asymmetrical prices may be charged to the users. Platforms match users with different needs, compared to offline village markets, search costs are reduced. Digital technologies, instead, exhibit increasing returns to scale as the number of consumers increases. The appreciation of standard regulatory principles to multi-sided markets is likely to lead to perverse results.