Price Setting in Practice: Optimal Regulation Strategies and Regulatory Concerns

1. Regulatory Price-Setting in Theory and Practice Seán Lyons (sean.lyons@esri.ie), ESRI & TCD 2 December 2011 PS6: Economic & Legal Aspects of Competition & Regulation

2. Agenda • Economics of price regulation • Goal 1: Preventing prices being “too high” • Goal 2: Preventing prices being “too low” • Goal 3: Geographical or distributional equity; other social objectives

3. Part A: Economics of price regulation

4. Economic rationale for price regulation • Health warning • But...some persistent market failures can best be addressed using sustained conduct regulation • Usually due to presence of market power or informational problems. • Normally applied by sectoral regulators or direct legislation rather than via competition regulators 4

5. Optimal price regulation • Optimal regulation: P=MC, if regulated firm has no fixed overheads • However, many price-regulated firms have large fixed overheads (implying increasing returns to scale) • C(Q)=cQ+K • If we set price = c, firm makes a loss of K • One option is to give a subsidy of K, allowing price to be set at c; but must be financed by lump sum tax to be efficient

6. Increasing returns illustration Green arrow shows lossto firm if P=MC

7. Second best approaches • Charging a price based on average cost C(Q)/Q lets firm break even, but leaves per unit price above marginal cost • Two part tariffs involve charging an access price to recover K, which allows a per unit price of c • ‘First best’ only if customers are homogeneous • Otherwise some customers, e.g. with low demand, may not buy service at all • Non-linear tariffs can help calibrate the mix of access and usage prices to customer types

8. Non-linear tariff illustration

9. Multi-product firms • What if the regulated firm produces two goods with joint fixed costs? • Costs must be allocated between them to set prices • Equi-proportionate markups: allocate overheads in proportion to c for each good • Ramsey prices: allocate overheads in proportion to the inverse elasticity of demand • i.e. services attracting greatest willingness to pay are allocated highest share of overhead • Minimises reduction in quantity demanded

10. Ramsey pricing illustration Product A: Elastic demand Product B: Inelastic demand

11. Informational problems in regulation • Optimal regulatory pricing rules demand a lot of information • Regulators have imperfect information, particularly about costs • Firms can exploit informational asymmetry to extract rents • Firms worry that regulators may expropriate investments once costs are sunk • Administratively practicable methods are needed to set regulated prices and underpin credibility of policy

12. Policy/competition concerns regulators wish to address • Excessive pricing • Predatory pricing, margin squeeze • High prices or lack of supply in high cost geographical areas or groups of users • Other reasons for preventing prices being too low or too high (e.g. political or capture motives)

13. Competing objectives • Low retail prices • Increased competition • Efficient level of investment • Efficient level of product quality • Maintain incentives for innovation • Allow regulated firm a normal return on capital; ensure it can finance its operations (“financeability”) • Universal service (geographical and distributional)

14. Goal 1: Preventing prices being “too high”

15. Rate of return / “cost of service” regulation • allowed revenue = allowed operating expenditure +allowed rate of return x (capital stock + allowed investment)+ depreciation • Avoids excessive profits in any given year; firm’s financeability is protected • Averch-Johnson effect: firm has an incentive to over-invest in capital (“gold-plating”)

16. Averch-Johnson effect • r = user cost of capital • w = average wage • c = average price of capital stock • K = stock of capital • Increasing the size of the capital stock allows higher profits for a given rate of return • Leads to inefficiently high capital-labour ratio

17. RPI-X price cap

18. RPI-X price cap • Provides an incentive towards greater efficiency, at least in early years of control • However, can lead to sizeable profits in some years; issue for public perception • Weaker incentives to invest than RoR control • If too tight, could compromise solvency of the regulated firm • Can lead to under-provision of quality of service if no supporting incentives/contraints included • Attractive option where static inefficiency is seen to be the main problem

19. Continuum between price cap and rate of return regulation • If price cap is only for a year, it is effectively a rate of return control • Price cap incentive effect weakens as the end of the period approaches • Setting either of them requires detailed info on actual and target level of efficiency, required investment, cost of capital, etc.

20. Menu regulation Menu regulation: offer regulated firms choice of regulatory contracts that encourage them to reveal true cost conditions they face; save on admin cost and informational demands Example: % reward for different levels of cost performance Adapted from Oxera (2008); for detailed discussion see Laffont & Tirole (1993)

21. Efficiency assessment • Traditional benchmarking • Risks ignoring differences in local context behind firms’ results • Statistical benchmarking • Requires consistent data on firms from many jurisdictions • Yardstick competition • Can only be done in jurisdictions with a significant number of regional suppliers; requires harmonised reporting of results

22. Wholesale market price regulation • Typically in the context of regulated access to facilities or services • Example: network services (non-competitive) sold to retail market (potentially competitive) • “Cost plus” – wholesale price cap based on costs of wholesale services • “Retail minus” – wholesale price cap based on discount from retail price of vertically integrated firm

23. Wholesale market price regulation

24. Related regulation of quality, access, investment and financial decisions • Quality and price are simultaneously determined in competitive markets; sometime quality omitted in regulatory controls • Quality may then be biased downward • If access is regulated, e.g. “must serve”, price will have to be regulated and vice versa • Step-in rights or special administration powers needed to ensure continuity of service and reverse incentive for over-leveraging

25. Goal 2: Preventing prices being “too low”

26. Regulatory tools in liberalised markets • Competition policy approach • Price < MC too low per se • Price between MC and AC requires examination • Margin squeeze – charging too much for wholesale input and/or too little for retail service such that efficient service-based entrants are excluded • Require incumbent to charge own retail unit 3rd party wholesale price • Margin squeeze tests

27. Goal 3: Geographical or distributional equity; other social objectives

28. Universal service / public service obligations • Uniform price rules with implicit cross-subsidies • Vulnerable user schemes: targeted cross-subsidies or tariff structure regulation • But also more extensive interventions • Anti-inflation measures / incomes policies • Fuel prices • Rent control • Anti-usury laws

29. Some references • Easy intro: Viscusi, Vernon & Harrington, 2005 (4th Ed.), Economics of Regulation and Antitrust, Ch.11 and first half of 12 • Armstrong, Cowen and Vickers, 1994, Regulatory Reform: Economic Analysis and British Experience. • Averch, H. and and Johnson, L., 1962, “Behaviour of the firm under regulatory constraint,” AER 52(5), 1053-1069. • Oxera, 2008, Menu regulation: is it here to stay? http://www.oxera.com/cmsDocuments/Agenda_Jan08/Menu%20regulation.pdf • Advanced: Laffont and Tirole, 1993, A Theory of Incentives in Procurement and Regulation.