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Stephen P. King1 Economics Program RSSS ANU August 2, 2001
would like to thank Philip Williams and an anonymous referee for their helpful comments on an earlier version of this paper.
Abstract Third-party access to major infrastructure facilities is a key component of National Competition Policy. In many situations, both through state regimes and access undertakings under the new part IIIA of the Trade Practices Act, access will be governed by explicit or implicit rate-of-return procedures. Infrastructure assets will be valued and translated into an allowable return for the owners. However, setting allowed returns is only the ﬁrst part of the regulatory process. This paper uses a simple model to evaluate the “secondbest” access prices under rate-of-return regulation. We show that optimal access prices will depend on the degree of downstream competition. With imperfect price competition and ﬁxed numbers of ﬁrms downstream, optimal access prices will ‘mimic’ downstream competition and reduce downstream proﬁts. With free entry downstream, optimal access pricing should determine an optimal level of downstream participation. We also show that the access provider’s incentives to introduce optimal access prices will depend on the degree of vertical integration.
National Competition Policy is an ambitious attempt to advance Australia’s microeconomic reform process, bringing all levels of government together to eliminate anticompetitive practices and streamline regulatory procedures. A key part of this policy is the creation of an access regime for major infrastructure facilities such as “electricity transmission grids, telecommunications networks, rail tracks, major pipelines, ports and airports” (Hilmer, et. al., 1993 p240). These facilities tend to have “natural monopoly characteristics” which prevent eﬀective competition. Allowing access to the services provided by these facilities should promote competition in associated upstream and downstream markets. For example, requiring an electricity transmission company to sell network access to outside ﬁrms will aid the development of competition in both the upstream generation market and the downstream retail electricity market. Access arrangements have been formalized under the Competition Principles Agreement between the federal, state and territory governments, and the new Part IIIA of the Trade Practices Act 1974. Infrastructure facilities can provide access after being declared by the National Competition Council (NCC), through an eﬀective state access regime or by voluntarily oﬀering an undertaking that is acceptable to the Australian Competition and Consumer Commission (ACCC). Regulators play a key role in each of these alternatives. The ACCC both judges the acceptability of undertakings and acts as the ﬁnal arbiter of access disputes for declared facilities. State regulators, such as the Victorian Oﬃce of the Regulator General and the Independent Pricing and Regulatory Tribunal of New South Wales have signiﬁcant roles in state access regimes. Rate-of-return considerations will feature prominently in access pricing. For example, draft version 1 of the national electricity market code proposed by the National Grid Management Council for transmission access, the New 1
South Wales rail access regime and the exposure draft of the third party access code released by the COAG Gas Reform Task Force all establish rules for access pricing based on the access provider earning a reasonable return on capital. When making a determination on an access dispute under Part IIIA of the Trade Practices Act 1974, the ACCC must take into account “the legitimate business interests of the provider, and the provider’s investment in the facility” (s44X1a). This will require the ACCC to evaluate the adequacy of the access provider’s rate-of-return. The ACCC must also have regard to the “legitimate interests of the provider” (s44ZZA3a) when considering an access undertaking. It is both equitable and economically sensible to allow infrastructure owners to earn a reasonable return on their investment. Without such incentives, future infrastructure development will be severely retarded. Explicit or implicit rate-of-return procedures are unavoidable when considering the dynamic eﬀects of access prices. Rate-of-return procedures are also attractive to regulators. There is a large literature on the practical application of rate-of-return regulation (see Gas Council of NSW 1996). Regulating the access provider’s proﬁts also appears to oﬀer a direct, pragmatic solution to the natural monopoly problem, while allowing considerable freedom to set access prices and encourage competitive sectors. While rate-of-return procedures may provide a convenient, practical way to limit monopoly abuse by access providers, these procedures only solve the ﬁrst part of the access problem. What are the optimal access prices once a rate-of-return constraint is in place? In particular, if the regulator wishes to maximize the total consumer and producer surplus derived from the relevant vertical chain of production, what access prices will best achieve this aim? Will these second-best access prices resemble the standard ﬁrstbest prices noted in the literature on public utility regulation? If not, what factors inﬂuence the second-best access prices? Do they depend on structural 2
parameters, such as the upstream or downstream technology, or the degree of vertical integration? How do they depend on downstream competition? Finally, can the regulator easily implement these second-best prices and will the access provider be willing to comply with them? This paper presents a simple model that provides (preliminary) answers to these questions. The model allows for a broad range of cost functions for both upstream and downstream production and places minimal restrictions on ﬁnal product demand. However, to better focus on the question of the constrained optimal access prices, the model will ignore standard issues of regulatory distortion associated with rate-of-return procedures.1 Access is provided by a single upstream facility which has a ﬁxed rate-base. We examine four diﬀerent competitive conﬁgurations. There is either free entry in the downstream market or a ﬁxed number of downstream competitors. In each of these cases, the access provider can either be vertically separated or can own one of the downstream participants. We place few restrictions on the nature of downstream competition.2 However, a crucial assumption in our analysis is that the downstream competitors must charge uniform prices for the ﬁnal product. This assumption can be justiﬁed either on the basis of lack of ﬁnal consumer information, resale between consumers or competition between the downstream participants.3 Our analysis leads to ﬁve broad conclusions regarding optimal access pricing under a rate-of-return constraint.
There are some well known problems with rate-of-return procedures. For example, infrastructure owners have incentives to artiﬁcially increase their rate base to raise allowed proﬁts (see Averch and Johnson 1962, Spulber 1989 and Carlton and Perloﬀ 1994). 2 For example, our model subsumes both Cournot competition and competition involving non-Cournot ‘conjectures’. 3 We consider the eﬀect of limited non-linear pricing by downstream ﬁrms in section 4. While we assume uniform pricing for the ﬁnal product, access can involve non-linear pricing. With a relatively small number of access seekers, enforcing non-linear prices for access will be relatively easy compared with setting non-linear prices for a large number of diﬀerentiated ﬁnal consumers.
1. If there are a ﬁxed number of downstream competitors, then secondbest access prices will ‘mimic’ downstream competition. In particular, access prices should be set to drive down the ﬁnal product price until either downstream proﬁts are driven to zero or price equals marginal cost. 2. With free entry downstream, competition drives downstream proﬁts to zero. Setting optimal access prices involves choosing the optimal downstream industry conﬁguration. In some situations, (static) social welfare is improved by allowing the upstream ﬁrm to earn above its regulated rate-of-return. 3. In either case, the second-best access prices under rate-of-return regulation require considerable industry speciﬁc information and bear little resemblance to standard ﬁrst-best public utility prices. 4. If the access provider is vertically separated or if there is free entry downstream then the upstream ﬁrm will be indiﬀerent to the access tariﬀ and will have no incentive either to oppose or to set the socially optimal access price. 5. If there are a ﬁxed number of downstream competitors, one of which is owned by the upstream ﬁrm, then there will be conﬂict between the regulator and the access provider. The socially optimal access prices will diﬀer signiﬁcantly from the access prices preferred by the access provider. These conclusions have clear implications for National Competition Policy.4 Rate-of-return of return procedures are likely to be widely used in practice
4 Armstrong, Cowan and Vickers (1994, chapter 5) also analyse optimal second-best access prices. Their model involves a weighted social welfare function with uniform access prices, constant marginal costs and either Bertrand or Cournot competition, and so diﬀers substantially from the model presented below.
to restrain monopoly facility owners. However, the second-best access prices that need to accompany rate-of-return regulation will often be complex, and will diﬀer depending on the degree of downstream competition and the nature of downstream costs. Setting desirable access prices may be easier if there is both free entry downstream and if the access provider is vertically separated from the downstream ﬁrms.
Competition under access
This section presents a simple model to capture the interaction between upstream rate-of-return regulation and downstream competition. The upstream service is produced by a monopoly whose proﬁts are capped by a maximum allowable rate-of-return. Downstream production requires access to exactly one unit of the upstream service for each unit of the ﬁnal product. For example, the ﬁnal product could be domestic electricity. The downstream electricity retailer requires access to the upstream transmission network in a ﬁxed proportion to ﬁnal sales.5 Downstream ﬁrms produce a homogeneous good subject to imperfectly competitive, uniform pricing. Each downstream ﬁrm must set a single price per unit for its product. This price will be at least equal to the downstream ﬁrm’s marginal cost and may be greater than this in equilibrium due to imperfect price competition. For example, if there was only a single downstream ﬁrm then that ﬁrm would set the monopoly price.6 While the downstream market has imperfectly competitive pricing, competition through entry will still inﬂuence the ﬁnal product price. For any given downstream cost structure (including the cost of access), the more
For simplicity the formal model assumes that there is no possibility of substituting another input for any part of the access service. However, we brieﬂy consider the issue of input substitution in section 4. 6 As the downstream output is homogeneous, all downstream ﬁrms will set the same price in equilibrium.
ﬁrms that are operating in the downstream market, the lower will be the ﬁnal product price. We consider two alternative cases. First, there may be a ﬁxed number of ﬁrms in the downstream market with no further entry, regardless of the proﬁtability of the incumbents. This case approximates the situation where there exist substantial barriers to new entry.7 Alternatively, there can be free entry in the downstream market. In this case, if incumbent proﬁts are positive, entry will occur. The increased competition due to entry will push the ﬁnal product price down towards marginal cost, with entry ceasing when economic proﬁts are driven to zero. The ﬁnal product price also depends on the marginal costs of the downstream ﬁrms. For any given number of downstream competitors, a rise in all ﬁrms’ variable production costs leads to a higher price and less production. The per unit access price will be an important component of downstream variable costs. If the upstream ﬁrm sets a two-part access tariﬀ then a rise in the per unit component of this tariﬀ unambiguously raises the marginal cost of production for downstream ﬁrms. A rise in the ﬁxed part of the access tariﬀ raises downstream ﬁxed production costs.8 The total cost function of a downstream ﬁrm producing q units of ﬁnal output is represented by T C(q) = F + FA + qPA + C(q) (1)
where F refers to any ﬁrm speciﬁc ﬁxed cost of production that is separate from the access tariﬀ, FA is the ﬁxed component of the access price, PA is the per unit price of access, and C(q) captures all other variable costs. We make the standard assumption that production costs are convex and nondecreasing in output with C(0) = 0. All downstream ﬁrms are identical and
7 These barriers may reﬂect government restrictions on entry, as existed in Australian telecommunications until July 1997. 8 To simplify the model so that access prices can unambiguously be translated into cost eﬀects, we only consider access prices that can be described by a two-part tariﬀ. As noted in section 4 this simpliﬁcation is convenient but not essential for the results.
we only consider symmetric outcomes in the downstream market. If there are a ﬁxed number of ﬁrms in the downstream market, then each of these ﬁrms may be making positive proﬁt without inducing entry. Each downstream ﬁrm’s proﬁt will be given by πD = qP − F − FA − qPA − C(q) (2)
where P is the downstream product price. In contrast, with free entry, ﬁrms will enter the downstream market until each ﬁrm earns zero economic proﬁt so that πD = 0.9 In either case, we denote the number of downstream ﬁrms by n. We assume that the ﬁnal product price is decreasing in total output.10 The upstream ﬁrm’s revenue is equal to nFA + nqPA . The ﬁrm also needs to pay its own production costs. For example, an upstream ﬁrm controlling a telephone network will pay ﬁxed costs associated with network maintenance, metering and billing and variable production costs such as switching. Some ﬁxed costs, denoted by f, do not depend upon the number of downstream ﬁrms. Other ﬁxed costs, denoted by fA , will be sensitive to this number. Variable production costs which depend upon total access sales are represented by c(nq). Again, assume that these costs are non-decreasing and convex with c(0) = 0.11 The access provider’s proﬁt is given by the diﬀerence between its revenues and costs πA = n(FA − fA ) − f + nqPA − c(nq) These proﬁts can be directly translated into a rate-of-return by dividing by the upstream ﬁrm’s rate-base. This return must satisfy the upstream ﬁrm’s regulatory constraint.
We ignore any “integer” problems associated with entry. Formally, the inverse demand curve is P (nq) with P 0 < 0. 11 Note that this implies that the upstream access provider may, but need not, have a natural monopoly technology. In particular, even if f = fA = 0 the upstream ﬁrm may have a natural monopoly technology if there are signiﬁcant sunk capital costs. It is these capital costs which form the ﬁrm’s rate base.
We will consider both the case where the access provider only operates in the upstream market, and where it is integrated with a downstream producer. An integrated access provider will have incentives to manipulate pricing and reported costs. For example, as the upstream access provider is constrained by rate-of-return regulation, it will pay the ﬁrm to shift costs from its downstream to its upstream operations. Loading costs onto the upstream operation does not reduce the allowed returns at this production stage but increases downstream proﬁts. Similarly, an integrated access provider will have signiﬁcant incentives to price discriminate between its own downstream operations and downstream competitors. In the extreme, the integrated access provider may want to set an access price which drives all downstream competitors out of business. The problems of regulatory distortion with an integrated access provider have been covered elsewhere. See for example Brennan 1987. King and Maddock 1996 present a summary of the relevant issues. Our discussion here is focussed on the optimal access tariﬀs under diﬀerent industry conditions, so we will assume that it is impossible for an integrated access provider to either manipulate its costs or to price discriminate between downstream competitors. Thus, an integrated access provider will simply receive the sum of the access proﬁts, πA and the proﬁts of one of the downstream ﬁrms. It is useful to characterize industry proﬁts. For any given number of downstream ﬁrms n, each of which produces ﬁnal output quantity q, total industry proﬁts are given by πA + nπD = nqP − nF − nfA − f − nC(q) − c(nq) (3)
Figures 1a and 1b show maps of industry isoproﬁt lines – the combinations of price and total ﬁnal product output such that, given the number of ﬁrms in downstream production, total industry proﬁts are constant. Industry marginal costs, c0 (nq) + C 0 (q) are represented by the NMC (net marginal cost) curve in ﬁgure 1. The industry isoproﬁt curves are horizontal where 8
they cross the NMC curve, and have a negative slope above the NMC curve and a positive slope below it. This reﬂects that, so long as industry price exceeds marginal cost, then expanding total output holding the price ﬁxed will raise proﬁts. Conversely, increasing output holding ﬁxed a price that is below marginal cost will reduce total proﬁt.12 The isoproﬁt curves depend on the number of ﬁrms in downstream production, but do not depend on the access price. This price is simply a transfer downstream producers to the upstream producer. If demand is “well behaved” then each isoproﬁt curve at most will cross the demand curve twice. For example, this will hold if the demand curve is linear or strictly concave. If the downstream ﬁrms are making zero proﬁts then the isoproﬁt curves reﬂect the access provider’s proﬁts. In such circumstances, each isoproﬁt curve will involve a unique rate-of-return for the access provider and the curves can be interpreted as isoreturn curves.
Rate-of-return regulation and second-best access prices
Using the simple model presented above, we can analyze the second-best access prices when there is either a ﬁxed number of downstream ﬁrms or free entry downstream; and when the access provider is either integrated into the downstream market or not integrated. As we rule out any manipulation of costs or access prices by an integrated access provider, integration will not alter the optimal access prices but will aﬀect the desire of the upstream access provider to implement those prices. We begin by considering the case of a ﬁxed number of downstream ﬁrms.
Formally, the slope of an isoproﬁt curve is given by (c0 (nq) + C 0 (q) − P )/Q, where Q = nq.
A ﬁxed number of downstream access seekers
Consider that the number of downstream ﬁrms is ﬁxed and given by n. The ¯ regulator desires to formulate access prices that 1. satisfy the access provider’s rate-of-return constraint, 2. provide non-negative proﬁts for downstream ﬁrms in equilibrium,13 and, 3. maximize the sum of consumer and producer surplus from the vertical chain of production. As there are a ﬁxed number of downstream ﬁrms, the industry isoproﬁt curves are ﬁxed. There are two separate cases, represented by ﬁgures 1a and 1b. In each case, the isoproﬁt curve labelled 0 represents a level of industry proﬁts that just satisﬁes the upstream ﬁrm’s rate-of-return constraint when the downstream ﬁrms earn zero proﬁt. The associated ﬁnal product price ¯ and quantity are labeled P 0 and nq 0 respectively.14 The socially optimal ﬁnal product price, in the absence of any rate-of-return constraint but with n ﬁxed, is shown by P ∗ . This price is where the NMC curve crosses the ¯ demand curve. In ﬁgure 1a, P 0 > P ∗ . In ﬁgure 1b, P 0 < P ∗ . Figure 1a represents the situation where the proﬁt constraints on both the upstream and the downstream ﬁrms will bind when the regulator sets the second-best access prices. The regulator will satisfy all three objectives
There may be circumstances where the regulator would like to induce exit by one or more of the downstream ﬁrms. This situation is similar to the case with free entry and is not considered separately here. The two cases will be identical if there are no downstream sunk costs and the optimal number of downstream ﬁrms under free entry is less than n. ¯ 14 We assume that this isoproﬁt curve intersects the inverse demand curve at least once. If this did not hold then it would be impossible for the regulator to set access prices that satisﬁed the upstream ﬁrm’s rate-of-return constraint with equality. We only consider the lower intercept of the isoreturn curve with demand. The higher intercept involves ﬁnal product pricing above unconstrained monopoly pricing and is never socially optimal.
by setting an access tariﬀ that pushes the ﬁnal product price to P 0 while simultaneously driving downstream proﬁts to zero. In such circumstances, the upstream ﬁrm’s proﬁts will just satisfy the return constraint. It is always possible to ﬁnd such access prices. To see this, consider the ﬁnal product price P 0 . If n = 1 then the downstream monopolist can be ¯ induced to set the ﬁnal product price equal to P 0 so long as the marginal access price, PA , is set low enough. The downstream monopolist will set ﬁnal product price and quantity to solve P 0 (q) + P − PA − C 0 (q) = 0 If the monopolist faced the true marginal cost of access then the optimal price for the downstream monopolist would be the industry monopoly price. This is given by P m in ﬁgure 1a. Lowering PA will then lower the optimal ﬁnal product price that the monopolist would set. For example, setting PA low enough (below zero) would induce the downstream monopolist to set an arbitrarily low ﬁnal product price. In between, there will be an access price that leads the monopolist to set the ﬁnal product price at P 0 . To ensure that all the industry proﬁts are received by the upstream access provider in this situation, the regulator simply has to set the correct up front access fee. If the ﬁxed number of downstream ﬁrms is greater than one, then the regulator merely needs to raise the marginal access price and lower the upfront access fee to reach the second-best ﬁnal product price. In the extreme, as n becomes large enough so that competition between downstream ﬁrms ¯ drives the ﬁnal product price towards the downstream marginal cost, setting PA = P 0 − C(q0 ) with an appropriate up front access fee will lead to the constrained optimal social outcome. These access fees will not be optimal if P 0 < P ∗ . Rather, if the industry is as depicted in ﬁgure 1b, the optimal access price will lead to a ﬁnal product price of P ∗ . At this price, industry proﬁts can accommodate both the upstream rate-of-return constraint and positive downstream proﬁts. By 11
the same argument as above, optimal access prices will involve setting PA so that downstream competition between the n incumbents drives the ﬁnal ¯ ∗ product price to P with FA set to transfer adequate proﬁts upstream. Both ﬁgure 1a and 1b are consistent with a natural monopoly technology upstream. In fact, they could apply to the same industry simply by altering the rate-of-return constraint. Figure 1a may represent a generous level of return, for example, where the access provider’s sunk capital is valued at current replacement cost when setting the rate base. Figure 1b may then represent the same industry where sunk upstream capital is valued at depreciated historic cost or at scrap. While the second-best access prices for a ﬁxed number of downstream competitors will vary with the exact number of competitors, the underlying rule is simple. Access prices should be set to drive down the ﬁnal product price until either the proﬁt constraints of upstream and downstream ﬁrms bind, or price equals marginal cost. If the access provider has no interest in downstream ﬁrm proﬁts then it will be indiﬀerent between setting these, or any other, access prices that satisfy the regulatory constraint. However, if the access provider is integrated with a downstream ﬁrm then there will be a direct conﬂict. An integrated access provider will want to maximize total proﬁts from upstream and downstream operations. This will involve maximizing total industry proﬁts and then maximizing its share of those proﬁts. The integrated access provider will want to set an access tariﬀ that induces a ﬁnal product price of P m .15 This can be achieved by setting an appropriate level of PA . The access provider will then want to seize as much of these proﬁts as possible by setting an upfront access fee FA that just satisﬁes its upstream rate-of-return constraint. The downstream subsidiary would then receive its 1/¯ th share n of the remaining proﬁts.
Remembering that P m is the joint proﬁt maximising price given n ﬁrms downstream, ¯ and will generally alter if n alters. ¯
Compared with the social optimum, an integrated access provider will wish to set the marginal access price too high so as to maximize the sum of upstream and downstream proﬁts. The conﬂict that this is likely to create between the access provider and regulatory authorities provides an additional reason why separation between the upstream and downstream markets may be a useful policy.16 Optimal access prices with a constant number of downstream competitors can be summarized by the following proposition. Proposition 1 Consider that the access provider’s proﬁts are constrained by a maximum allowed rate-of-return and that there are a ﬁxed number of downstream ﬁrms. To maximize social surplus, the marginal access price should be set so that downstream competition results in a ﬁnal product price given by the maximum of P ∗ and P 0 . The ﬁxed access fee should then be set so that the upstream ﬁrm exactly meets its return constraint. If the access provider is vertically separated from the downstream market then it will be indiﬀerent between these and any other access prices that satisfy the return constraint. If the access provider is integrated with a downstream ﬁrm then it will strictly prefer an alternative access tariﬀ unless P 0 = P m .
Free entry downstream
Under free entry, the number of ﬁrms in the downstream market will depend, in part, on the relevant access tariﬀ. In terms of ﬁgures 1a and 1b, free entry will always drive the proﬁts of the downstream ﬁrms to zero so that all industry proﬁts accrue to the access provider. The isoproﬁt curves can be interpreted as isoreturn curves for the access provider, so that setting an allowed rate-of-return for the upstream ﬁrm identiﬁes a speciﬁc isoreturn curve on which the industry will operate.
However, issues of regulation under asymmetic information are also relevant here. See Gilbert and Riordan (1995) and Vickers (1995).
The isoreturn map, however, will depend on the number of downstream ﬁrms. Access pricing will have a role in determining an optimal level of downstream participation. For example, consider that C 0 (q) > 0 but both F ≈ 0 and fA ≈ 0. Downstream ﬁrms face increasing marginal production costs but downstream production involves no ﬁxed costs (other than those associated with the access tariﬀ). In this situation, as more ﬁrms enter the downstream market, the NMC curve will shift to the right and the isoreturn curves will move down the demand curve. Any ﬁxed rate-of-return will be associated with a lower price and a higher quantity as the number of downstream ﬁrms increase. Cost minimizing and welfare maximizing production will require that the upstream monopolist sets an access tariﬀ that encourages entry. In terms of ﬁgures 1a and 1b, as the number of ﬁrms alters, the NMC curve and the isoproﬁts will shift, as will P 0 and P ∗ . For any ﬁxed n consider the maximum of P 0 and P ∗ . Given the upstream access provider’s allowed rate-of-return, the socially optimal level of n will minimize this maximum price. This is illustrated in ﬁgures 2a and b, where n represents the socially ˜ ˜ 0 and P ∗ . In ﬁgure 2a, ˜ optimal level of entry, with the associated prices P ˜ ˜ ˜ ˜ P 0 > P ∗ while in 2b, P 0 < P ∗ . ˜ ˜ First, consider that P 0 > P ∗ . Given n, the optimal per unit access ˜ price will be set so that the equilibrium in the downstream market results ˜ in a ﬁnal good price of P . From the discussion in section 3.1 such a per unit access price can always be found. The optimal ﬁxed access fee will then transfer all downstream proﬁts to the upstream ﬁrm. By construction, this will simultaneously satisfy the downstream free-entry condition and the upstream rate-of-return constraint. ˜ ˜ If P 0 < P ∗ , as in ﬁgure 2b, then the zero-proﬁt constraint imposed on downstream ﬁrms by free entry and the upstream ﬁrm’s rate-of-return constraint, are inconsistent with eﬃcient pricing for the socially optimal number ˜ of ﬁrms. Given n, the socially optimal price, P ∗ , is set where demand inter˜ sects net marginal cost. But at this price, industry proﬁts are greater than 14
the allowed upstream proﬁts. Enforcing the rate-of-return constraint will not maximize static social welfare as it requires either suboptimal ﬁnal product pricing and/or an ineﬃcient number of downstream participants.17 To maximize (static) social surplus, the regulator would ﬁnd it desirable to loosen the regulatory constraint imposed on the access seeker, raising the allowed return until the 0 isoproﬁt was consistent with socially optimal pricing. With free entry downstream, optimal access prices do not have to drive downstream proﬁts to zero. Standard competition achieves this goal. However, because the number of downstream ﬁrms is variable, access prices need to solve a diﬀerent problem – choosing a technically eﬃcient level of downstream entry. The regulator’s problem under free entry is akin to a single producer determining the optimal number of plants or factories and how to allocate production over those plants. For example, if downstream production involves increasing marginal, but low ﬁxed costs, then an optimal access tariﬀ will involve a low ﬁxed fee to encourage entry but a relatively high per unit access charge. If downstream technology involves increasing returns to scale then the optimal access tariﬀ will limit entry by charging a high ﬁxed fee but will involve a low per unit fee to oﬀset the monopoly power of the successful access seeker. If the regulated return for the access provider is set too tightly, however, it may be impossible to simultaneously establish an eﬃcient downstream conﬁguration, optimal ﬁnal product pricing and to satisfy the rate-of-return constraint. This problem can be rectiﬁed by loosening the return constraint. Proposition 2 With free entry in the downstream market, and given an allowed rate-of-return for the upstream ﬁrm, optimal ﬁxed and per unit access prices should be set so that free entry will lead to a cost minimizing conﬁguration of downstream ﬁrms when the allowed rate-of-return is exactly satisﬁed.
However, if the rate-of-return constraint is necessary to ensure eﬃcient investment, then enforcing the constraint may improve intertemporal welfare.
The conﬂict, noted in section 3.1, between the regulator and the access provider when the latter is integrated into the downstream market, is absent when there is free entry downstream. Competition in the downstream market will drive the proﬁts of all relevant ﬁrms to zero, including any ﬁrm owned by the access provider. Consequently, an integrated access provider has no more incentive to manipulate the downstream market than an access provider who is not integrated. That said, in neither case will the access provider have the correct incentives to set the socially optimal access prices. While free entry downstream removes some of the potential for conﬂict between the regulator and the access provider, it does not excuse the regulator from the diﬃcult task of determining and implementing the socially optimal access prices.
Access prices and policy
When regulators are bound by rate-of-return considerations they face a twostage decision making process. First, regulatory authorities need to decide on an allowable rate-of-return for the upstream monopolist. Setting this rateof-return may involve trading oﬀ the access provider’s proﬁts and the social welfare that accrues from ﬁnal market production. This trade oﬀ is easily seen from ﬁgures 1a and 2a. For a ﬁxed number of ﬁrms in the downstream market optimal access prices drive downstream proﬁts to zero. Given n, the higher the allowed upstream return, the higher will be the ﬁnal product price in equilibrium and the lower will be total social welfare. With free entry, competition eliminates downstream proﬁts and access prices can focus on the optimal industry structure. However, given optimal downstream participation, the trade oﬀ between the allowed rate-of-return and ﬁnal product prices remains. The trade oﬀ between upstream rate-of-return and welfare can pose a signiﬁcant problem for regulators. A low rate-of-return may deter investment. A generous rate-of-return not only encourages excessive investment but also 16
directly undermines economic welfare. If the regulator suﬃciently lowers the allowed return, then the trade oﬀ between return and ﬁnal product pricing will cease to be relevant. This is illustrated in ﬁgures 1b and 2b. The relevant rate-of-return may be extremely low, particularly if upstream production involves high levels of sunk capital and increasing returns to scale technology. The second stage of the regulatory process, setting second-best access prices, is also problematic. The optimal access prices characterized in propositions 1 and 2 diﬀer signiﬁcantly from standard ﬁrst-best regulation. In particular, the ﬁrst-best rule of setting the marginal (access) price equal to short run marginal cost (see Doyle and Maher 1992, Kahn 1988 and Slater 1989) will almost never hold. This is to be expected. Unlike standard public utility theory, access pricing involves a vertical production chain. It is well known that when the downstream industry, for example, is characterized by monopoly, then the optimal marginal access price will diﬀer from short-run marginal cost (Vickers and Yarrow 1988). In this sense, proposition 1 simply formalizes a well known result in the context of rate-of-return regulation, although it also expands this result to allow for an integrated access provider. Proposition 2 also incorporates a well known issue in industrial organization, but one that has been applied less often to access pricing. It has long been recognized that if there is imperfect price competition between ﬁrms in an industry, then free entry will usually not lead to a socially optimal number of ﬁrms (for example, Mankiw and Whinston 1986). By controlling a critical input price, the regulator can directly control the level of downstream entry and consequently should use the regulated access prices to determine an optimal industry conﬁguration. The relevant access prices will depend on the nature of downstream technology as well as upstream marginal costs. With free entry downstream and upstream rate-of-return regulation access prices are only concerned with industry conﬁguration. If there is no social preference over the number of downstream ﬁrms then any access prices that 17
satisfy the relevant level of upstream returns in equilibrium will be equivalent. To see this, consider that C 0 (q) is constant and both F = 0 and fA = 0. Society is indiﬀerent to the conﬁguration of downstream production. One downstream ﬁrm can produce the ﬁnal product as eﬃciently as one hundred. ˜ n in ﬁgure 2a is not well deﬁned and P 0 and nq 0 will not depend on n. Any ˜ ˜˜ ˜ ˜ access prices that lead to an equilibrium price of P 0 in the ﬁnal product market will be socially equivalent. The regulator will be indiﬀerent between any access prices that satisfy the rate-of-return constraint. There are a large variety of such access tariﬀs involving diﬀerent numbers of downstream participants.. In this special case, it is clear that the regulator can take a “light handed” approach to access pricing. Once the regulated rate-of-return is set, together with relevant rules on transfer pricing and “ring-fencing” upstream and downstream operations if the access provider is integrated, then the regulator can allow the upstream ﬁrm to set the access tariﬀ. However, such “light handed” access pricing will not be applicable in general. Setting an optimal tariﬀ often requires considerable industry speciﬁc information that may not be readily available. The regulator is unlikely to know whether the per unit access price should be above or below short-run marginal cost. A “third-best” compromise policy when the regulator faces a poverty of information could involve setting the per unit access price equal to short-run marginal cost with the upfront fee set by the rate-of-return constraint.18 Setting PA equal to the short-run marginal cost would have the beneﬁt of minimizing any undesirable downstream input substitution. While our analysis has assumed that one unit of access is always required for each unit of the ﬁnal product, in most situations some substitution possibilities will be available. Setting a per unit access price that deviates from short-run marginal cost can lead downstream ﬁrms to either overuse or un18
Ng 1983 discusses third-best policies.
deruse access.19 Requiring the per unit access price to be set at short-run marginal cost, with the upstream ﬁrm maintaining discretion over any ﬁxed access fee subject to the rate-of-return constraint, may represent a reasonable regulatory compromise. Our analysis also highlights the potential conﬂict between an integrated access provider and the regulator. If there are a ﬁxed number of downstream ﬁrms, one of which is owned by the access provider, then as proposition 1 notes, the upstream ﬁrm will oppose socially optimal access prices. Under free entry in our model, the access provider is indiﬀerent between access prices and has no incentive to determine the tariﬀ that will lead to a desirable number of downstream ﬁrms. In practice, the access provider may have reasons to distort the downstream market. For example, if signiﬁcant downstream entry is considered indicative of a “successful” access regime then the upstream monopoly may ﬁnd it politically desirable to set an access tariﬀ that encourages excessive downstream participation. Our analysis has assumed that the access provider is limited to setting two-part access tariﬀs. It is clear that this is unimportant for propositions 1 and 2. If the access provider can set any non-linear prices that include both a ﬁxed and a volume sensitive component then the two propositions remain unchanged. Industry isoproﬁts were constructed independent of the access tariﬀ. With a ﬁxed number of downstream participants and given the allowed rate-of-return, optimal access pricing involves minimizing downstream proﬁts and choosing the ﬁnal product price and output level that maximizes social welfare. With free entry downstream, optimal access prices are focussed on establishing a cost minimizing downstream conﬁguration. If the access provider is restricted to uniform pricing then our results
This is not as staightforward as it may seem. If there are only a few downstream ﬁrms then they may attempt to use their access purchases to manipulate the per unit price. After paying the upstream ﬁrm the ﬁxed access fee, the downstream ﬁrms have an incentive to overbuy access services as, given the allowed rate-of-return, this will force the upstream ﬁrm to lower its per unit price.
would alter. For example, with a ﬁxed number of downstream competitors and uniform access prices, it would generally be impossible to simultaneously eliminate downstream proﬁts and satisfy the rate-of-return constraint. Social welfare would be unambiguously lower if the ﬂexibility of non-linear access tariﬀs was removed and there is no rationale in our model to limit the access provider or regulator to uniform pricing. We also assumed that downstream ﬁrms were restricted to uniform pricing. This assumption is less benign. If downstream ﬁrms can set non-linear tariﬀs then the link between the allowed upstream rate-of-return and the downstream marginal price is reduced. For example, consider that the downstream industry involved a single ﬁrm and that this ﬁrm could set a twopart tariﬀ for the ﬁnal product. The proﬁt maximizing tariﬀ for the downstream ﬁrm would involve setting the marginal price equal to the downstream marginal cost, including the marginal access tariﬀ, and removing all consumer surplus through up-front fees. The socially optimal access price would then set PA equal to the true marginal cost of supplying access at the socially optimal quantity. The upfront access fee would simply divide upstream and downstream proﬁt. The actual proﬁt of the access provider would rise and fall with this upfront fee but would only inﬂuence the division of proﬁts, not total social surplus. Downstream ﬁrms usually will be limited in their ability to set non-linear tariﬀs. In part, this will be due to asymmetric information. Even a downstream monopolist will be unable to tailor upfront fees perfectly to each consumer. If the downstream ﬁrms cannot distinguish between diﬀerent types of consumers, optimal prices will often involve a per unit price above downstream marginal cost (see Oi 1971, Varian 1989). The issues raised in this paper will re-emerge under such a distortion. Competition between downstream ﬁrms will also limit the ability of each ﬁrm to set non-linear tariﬀs. While removing the assumption of uniform ﬁnal product pricing will reduce the impact of our arguments, the problems of setting second best access 20
prices that we note above are unlikely to disappear..
For practical purposes, rate-of-return procedures are likely to dominate access regulation. Given this, the analysis presented in this paper provides some important results on second-best access pricing. In particular, if the upstream access provider is either explicitly or implicitly regulated on rateof-return criteria then the role played by access pricing will diﬀer depending on the conditions of entry downstream. If the number of ﬁrms downstream is ﬁxed, then optimal access pricing will replace competition and remove downstream proﬁts. In contrast, if competition, through free entry, is allowed to operate downstream, then optimal access pricing involves choosing a cost-minimizing conﬁguration of downstream ﬁrms. The ease with which regulators can implement optimal access prices will depend on both their knowledge of downstream costs and any integration by the access provider into the downstream market. Regulators will rarely have the information required to set second-best access prices. However, their task may be made easier by allowing freeentry downstream and vertically separating the access provider to remove regulatory conﬂict. These proposals diﬀer signiﬁcantly from the pre-1997 Australian telecommunications reforms. The structural reforms that have occurred, for example, in the Victorian electricity distribution and retailing sectors, are closer in spirit to the policies suggested by our analysis.
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