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Published by: Core Research on Jan 09, 2009
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Efficient Investment Pricing Rules and Access Regulation*
Joshua S. Gansand Philip L. Williams
Melbourne Business School
University of Melbourne
3 July, 1998

This paper reviews recent advances in regulatory theory concerning the effect of access pricing regulation on incentives to invest in infrastructure. We demonstrate that regulation has a dual role of ensuring that investment costs are themselves shared by multiple users of a facility and that potential providers compete to invest in a timely manner. Our paper, therefore, provides a rationale for using fixed access charges to allocate investment costs so as to ensure timely investment and competition.

*Parts of this paper previously appeared in Gans and Williams (1998a). We thank David Briggs and

Stephen King for helpful comments. Responsibility for all views expressed in this paper lies with us. All correspondence to: Joshua Gans, Melbourne Business School, 200 Leicester Street, Carlton Victoria 3053; E-mail: J.Gans@mbs.unimelb.edu.au; Fax: (03) 9349 8133.


Previous discussions of the role of Part IIIA of the Trade Practices Act have focussed on the optimal use of essential facilities. From an economist\u2019s viewpoint such facilities have a proportionately high level of sunk costs relative to operating costs. Hence, once a facility is built, social efficiency dictates that the facility be used intensively. In particular, if usage prices \u2013 or the prices of final goods that use the facility as a key input \u2013 are not close to short-run marginal (or avoidable) cost, usage will be less than socially optimal. Of particular concern in trade practices law is, of course, the role of competition in facilitating optimal usage. If a facility is owned by a vertically integrated producer, there is concern that individual facilities may be restricted in their use. This is a traditional problem of monopoly power. In this case, the firm who owns the facility restricts access to it by other firms, thereby creating an entry barrier allowing it to effectively restrict access to it by final consumers.

Part IIIA is designed to facilitate optimal use by encouraging facility owners to give access to firms who might use the infrastructure as an input. This has the advantage of avoiding costly duplication of the facility as well as reducing entry barriers to downstream competitors. Moreover, economists have a good notion of the access pricing rule that should be set to encourage such use and competition \u2013 access usage charges should by set equal to short-run marginal cost. Any higher and a facility will be under utilised. Any lower and the facility will be used too much. Issues of asymmetric information and operating cost reductions tend to mean that in practice this benchmark is not reached.1 However, the benchmark remains an important pricing goal.

The problem with this focus, however, is that it neglects the dynamic effects of access regulation. That is, while economists have established principles to guide pricing behaviour for a facility that has been built, only recently has attention been turned to the critical issue of incentives to build the facility in the first place. After all, to the extent that static access regulation diminishes the use of monopoly power over the asset, it also


potentially reduces profits that can be earned by a private investor. Hence, there is a potential concern that such regulation might deter investment that would otherwise be socially optimal. After all, no competition can easily be preferred to no production at all.

In order to see this problem clearly, imagine that the Trade Practices Act included lawnmowers as an \u201cessential facility,\u201d in this case, for the production of neat gardens. The Smith family are considering purchasing a lawnmower. However, before they do this they notice that their neighbours, the Jones family, have a nice new lawnmower. The Smiths propose to the Joneses that perhaps they could borrow their mower for one day a week. This they argue would not inconvenience the Joneses who use the lawnmower themselves for one day each week. Of course, the Smiths will compensate the Joneses for fuel used and physical depreciation caused. This offer is, of course, consistent with static notions of pricing efficiency. That is, given that the lawnmower exists and is not fully utilised by the Joneses (i.e., there is excess capacity), if the Smiths are will to bear the costs of their usage, it is socially efficient for them to be granted access to the Jones\u2019 mower. To the extent that there is a legal stipulation for the Joneses to grant the Smiths access, so much the better.

The problem, however, is that the Joneses were considering purchasing an electric weeder. All other things equal they might have decided to go ahead with the purchase, even if they did not expect to rent it out for some days of the week. Seemingly the prospect of renting would only enhance the Joneses benefits from purchasing the weeder. However, the Jones family are sophisticated thinkers. They reason that it might be better to see if someone else on the street purchases the weeder first. That household would bear the capital costs of the weeder while the Joneses could simply rent it out for one day a week. Under a proposal such as that of Smith for the mower, Jones would only have to pay for the operating expenses of the weeder \u2013 a negligible amount relative to the purchase costs.

1For a discussion of such deviations see Armstrong et.al. (1994) and King and Maddock (1996).

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