LECTURE 2 - AGENDA The role of cost information in pricing decisions Pricing in regulated (monopoly) situations Common cost terms used in EU Prof. Teemu Malmi 2016

THE ROLE OF COST INFORMATION IN PRICING DECISIONS What is the traditional accounting based approach? What alternatives we have for pricing? What are the problems of traditional accounting based approach? Remember: COST = PRICE Only some regulatory environments makes an exception to this rule Good cost information can be valuable in pricing decisions Prof. Teemu Malmi 2016

LECTURE 2 - AGENDA The role of cost information in pricing decisions Pricing in regulated (monopoly) situations Common cost terms used in EU Prof. Teemu Malmi 2016

WHY DO WE NEED TO STUDY PRICING IN REGULATED SITUATIONS? First of all, there are lot of regulated areas in our society, perhaps more than you currently think off It does not matter whether we work for regulated entity, one which aims to compete with regulated entity, or for regulator, we need to understand how to deal with costs adequately Failure to do so may cost large sums of money, as many court cases show Prof. Teemu Malmi 2016

PRICING IN REGULATED MONOPOLY SITUATIONS In these environments pricing is usually required to be based on costs On top of the costs a reasonable profit margin is allowed What is reasonable profit margin and how do we estimate it? How do we determine the cost of any particular product or service in situations where –There are a lot of common costs –Output volumes vary –Etc. No wonder these issues are commonly discussed at courts Prof. Teemu Malmi 2016

LECTURE 2 - AGENDA The role of cost information in pricing decisions Pricing in regulated (monopoly) situations Common cost terms used in EU Prof. Teemu Malmi 2016

LEGAL TERMINOLOGY RELATED TO COSTS Average avoidable cost (AAC) is the average of the costs that could have been avoided if the company had not produced a discrete amount of (extra)output In most cases, AAC and the average variable cost (AVC) will be the same, as it is often only variable costs that can be avoided. Note: AAC can include also fixed costs The Commission will take AAC as the appropriate starting point for assessing whether the dominant undertaking incurred or is incurring avoidable losses. If a dominant undertaking charges a price below AAC for all or part of its output, it is not recovering the costs that could have been avoided by not producing that output -> predatory pricing! Prof. Teemu Malmi 2016

LEGAL TERMINOLOGY RELATED TO COSTS European Commission try to liberalise telecommunications markets across Europe and to enable effective competition by tearing down incumbent operators’ monopolies Interconnection pricing is seen as a matter of prime importance New market entrants should be able to offer services to end-users, thereby using the incumbent’s network to gain access to the desired customer group. EU: Interconnection tariffs should be cost-oriented and preferably be determined implementing the concept of long run average incremental costs (LRAIC) Prof. Teemu Malmi 2016

LRAIC LRAIC calculates the cost of providing a predefined increment One asks himself what the cost would be, seen from a long-term perspective, of adding a service or product to an existing portfolio of services and/or products. The increment can be broadly defined as the provision of any additional quantity of economical output, be it a single new service or product, a whole set of new services/products or just a capacity increase Prof. Teemu Malmi 2016

LRAIC Initial conditions are of importance The initial products/services determine whether shared costs are or are not to be taken into account when calculating the cost of the increment Definition of the increment is crucial Cost of the increment depends on its definition since a distinction is being made between LRIC (Long Run Incremental Costs) and LRAIC (Long Run Average Incremental Costs) Prof. Teemu Malmi 2016

LRAIC In a situation where additional shared costs are required for realising the increment (e.g. the set-up of a new server for network management purposes), an allocation method has to be defined in order to attribute these costs to the constituent products of the group LRAIC-approach will identify allocation keys that allocate a part of the shared costs to all products of the increment and thereby calculates an average price for the various products LRIC-method will allocate these shared costs to the product that is firstly added to the increment Prof. Teemu Malmi 2016

LRAIC IN PRACTICE Top Down approaches –Fully Distributed Cost – Historical Cost Accounting no correction for inefficient operation or obsolete technologies –Fully Distributed Cost – Current Cost Accounting also distributes all costs, but aims to adapt them to today’s technological situation = revaluation of the operator’s assets at current prices Still no correction for inefficient operation –efficiency ratios used to accomplish full efficiency Prof. Teemu Malmi 2016

LRAIC IN PRACTICE Bottom-up approaches –Scorched Earth approach or the greenfield scenario Setting up a complete new network today, same functionality, 100% efficiency –(Modified) scorched node Relates to assumptions regarding the physical paramters of the network Costs tend to be higher with top-down than bottom-up methods Prof. Teemu Malmi 2016

REFLECTION Key learning points today? Prof. Teemu Malmi 2016