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 2

3. Part A: Economics of price regulation 3

4. Economic rationale for price regulation Health warning Health warning But...some persistent market failures can best be addressed using sustained conduct regulation o 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 5

6. Increasing returns illustration 6 Green arrow shows loss to 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 7

8. Non-linear tariff illustration 8

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 o i.e. services attracting greatest willingness to pay are allocated highest share of overhead o Minimises reduction in quantity demanded 9

10. Ramsey pricing illustration 10 Product A: Elastic demandProduct 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 11

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) 12

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) 13

14. Goal 1: Preventing prices being too high 14

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; firms financeability is protected Averch-Johnson effect: firm has an incentive to over-invest in capital (gold-plating) 15

16. Averch-Johnson effect o r = user cost of capital o w = average wage o c = average price of capital stock o 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 16

17. RPI-X price cap 17

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 18

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. 19

20. Menu regulation 20 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 Ex ante cost proposal relative to regulator est. Ex post actual cost -10%-5%0%+5%+10% -10%3.253.193.002.692.25 -5%1.501.561.501.311.00 0%-0.25-0.060 -0.25 +5%-2.00-1.69-1.50-1.44-1.50 +10%-3.75-3.31-3.00-2.81-2.75 Adapted from Oxera (2008); for detailed discussion see Laffont & Tirole (1993)

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

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 22

23. Wholesale market price regulation 23

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 o 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 24

25. Goal 2: Preventing prices being too low 25

26. Regulatory tools in liberalised markets Competition policy approach o Price < MC too low per se o 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 o Require incumbent to charge own retail unit 3 rd party wholesale price o Margin squeeze tests 26

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

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 o Anti-inflation measures / incomes policies o Fuel prices o Rent control o Anti-usury laws 28

29. Some references Easy intro: Viscusi, Vernon & Harrington, 2005 (4 th 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 http://www.oxera.com/cmsDocuments/Agenda_Jan08/Menu%20regulation.pdf Advanced: Laffont and Tirole, 1993, A Theory of Incentives in Procurement and Regulation. 29