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Theory of Price Regulation

Agenda• 1 Introduction

– 1.1 Objective of regulation– 1.2 Rate balancing

• 2 Different approaches of pricing regulation• 3 Price-cap regulation

– 3.1 The formula and factors– 3.2 Miscellaneous issues in price-cap regulation

• 4 Price regulation in interconnection• 5 Price regulation in Hong Kong• 6 Conclusion

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Introduction 1/3

Price regulation objectives

• Financing objectives: to make operators get sufficient revenue to be viable

• Efficiency objectives: to reflect resource scarcity properly and to maximize the productivity

• Equity objectives: to distribute the welfare benefits between operators and consumers, and also among different consumer groups fairly.

• Other objectives can be to restrict the anti-competitive pricing

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Introduction 2/3

Rate balancing• Price should be closely aligned to its cost • Unbalanced price structure is not sustainable in the competitive

environment but occurs regularly in unregulated monopoly• Ramsey pricing is widely used to recover the fixed and common costs • Ramsey pricing: price is raised above marginal cost more for a lower

demand elasticity (sensitivity) service and less for a higher demand elasticity service.

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Introduction 3/3

Peak/off-peak pricing:

• Prices are set at a higher level in peak time to discourage use of facilities and transfer demand to off-peak periods.

• Advantages– Capacity utilization maximized– Traffic congestion reduced– Quality of service improved, – Purchase of additional equipment avoided.

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Different approaches 1/3

• Oligopoly era: a partly competitive and partly regulated market with a small number of operators

• Discretionary price– government operates the network to promote consumer-to-consumer

equity objectives – Below-cost local connection price and over-cost long distance or

international connection price.– Unbalanced and inefficient price structure – Because of some political reason, price is raised to meet the require

revenue, part of the revenue deprived … all these threaten the viability of operators.

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Different approaches 2/3

Rate-of-return regulation

• Aims to limit monopoly profit to a reasonable level

• Adjust the price to cover the calculated revenue requirement.

• This violates the efficiency objectives for there is no incentive for operators to reduce their costs.

• It will lead to over-investment, various "cost-padding"

• What a reasonable price is?

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Different Approaches 3/3

Price-cap regulation

• Restrict the price rather than the profit.

• Encourages cost reduction and innovation.

• A price 'floor' is also important to prevent below cost pricing which is used to exclude lower-cost new entrants.

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Price-cap regulation 1/5

Basic formula: Pt = P0 * (1 + I - X) ^t

• Pt = P0 * (1 + I - X) ^t

• P0 = baseline price-cap

• Pt = price-cap during year t after the institution of price-level regulation

• I = rate of inflation

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Price-cap regulation 2/5

‘I’ factor• Price can be indexed to the overall level of input costs.• Regulators can focus on the whole industry instead of a specific operator

in rate-of-return regulation. Thus encourage operator to achieve cost reduction and innovation.

• No industry-specific index, use broader reasonable inflation indices – CPI (Consumer Price Index): UK, Australia– PPI (Producer Price Index) with its sub indices.

• Any price index has limitations with time fluctuations so adjustment mechanism is needed

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Price-cap regulation 3/5

X' factor• ‘X’ should pose a significant, but not insuperable challenge to the

operator. • Two main approaches to determine the ‘X’ factor • Historical productivity method:

– carry out TFP (Total Factor Productivity) as basic offset. – X value should be equal to the difference between the productivity of

the operator and the economy as a whole to make sure that every industry else being equal to avoid loss of investment in telecommunication.

• Regulatory benchmarking method: – In some emerging market or the regulation is changing from

discretionary price – Adjustments are more important than basic offset

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Price-cap regulation 4/5

Time period

• The productivity achieved should not be passed on to the consumer at once to cause possible dilution of incentives.

• A proper period should be between 3 to 5 years

– FCC adopted a 4-year price-cap period with AT&T

– Oftel with BT for 4 years also except the initial price-cap for 5 years.

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Price-cap regulation 5/5

Miscellaneous issues in price-cap regulation• Service Baskets

– The API (Actual Price Index): price increase of individual services times their weight determined by their revenues.

– API should be equal or less than PCI (Price-cap Index). – Sub-cap index for one specific service

• Profit Sharing (PS) Mechanism, a complementary choice– Regulator imposes a sharing rule if one operator is making excessively high

profits. – If the operator does not agree to it, regulator revokes the contract. – To operators, the threat of revocation is very costly because of the capital

intensive investment during contract period.• The price-cap regulation should not be applied to the launch of innovative services

– There is no fierce effective competition in market. – There is need for operators to exploit new markets and customers. – Profit can be seen as a reward for innovation and introduction of new services. – Profit can be seen a signal for new comer and trigger competition.

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Price regulation in interconnection 1/ 3

LRIC (Long Run Incremental Cost): the most favored costing method • Costing method: historical data or forward-looking approach

– Historical data approach: price their service merely based on historical investment.

– The forward-looking approach: operators are supposed to respond competition by price adjustment more actively

– Forward-looking approach is preferred• LRIC: the most widely accepted forward-looking costing approach

– Used widely in retail and wholesale market– Estimated on the basis of current technology and best available

performance standards. – The European Commission has adopted LRAIC (Long Run Average

Incremental Cost) as its preferred costing methodology.

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Price regulation in interconnection 2/3

The use of price-cap regulation in wholesale market • The operator raises its interconnection charges and lowers the retail prices t

o squeeze the profit margin to exclude competitors or new comers. • In CPP regime, the charge is relatively high when a fixed operator pays the

corresponding mobile operator for a fixed-to-mobile call. – Oftel modified the mobile operators' licenses in April 2003 to require the

first 15 per cent reduction by July– Further cuts of 15 per cent in each year for the next three years

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Price regulation in interconnection 3/3

Other regulation principles

• Unbundled charges: no service provider shall be charged for any interconnection facility it does not seek or require

• Universal service and ADC (Access Deficit Contributions) charges: the interconnection charges should be separated where the cost of a particular component vary significant in different locations

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Price regulation in Hong Kong • In 1975, Scheme of Control (SoC) (Rate-of-return regulation) was established. • After 1991, the government and HKTC mutually agreed to move to price-cap regul

ation • In 1993, the Telephone Regulation set out the initial 3-year-long an overall price-ca

p and two sub-caps. • Since 2003, all telecommunication sectors in Hong Kong fully liberalized.• At present, almost all retail prices are without regulatory influence.• Only PCCW HKT (former HKTC)'s price for local fixed network service are subject

to regulation since it is designated a dominant operator.• Even in a competitive market, the regulator must maintain vigilance

– In early 2000, all mobile operators announced an increase in the monthly charge at almost the same time.

– The price rise was withdrawn after OFTA declared that it would conduct an investigation to see whether any collusion was involved.

• IDD service was not under price control for free competition– Some services costs has fallen by more than 98%. – The incumbent is no longer dominating so pricing regulation for IDD service is

no longer necessary now.

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Conclusion

• Price regulation should be set to meet its objectives. • In principle, price is supposed to be aligned with its cost; in practice,

Ramsey pricing can be adopted to recover the costs. • The most favored costing method is LRIC• Price-cap regulation is widely adopted both in retail and wholesale market.• Price-cap regulation restrict the price rather than the profit. Thus, it

encourages the operator to reduce cost and to innovate. • When applying price-cap regulation formula, the inflation, “X” factor, and

time period should be picked up carefully.• Price control should not be use in launch of innovative service.• Profit sharing mechanism can be used as a complementary option to favor

customers. • In wholesale market, principles have already been set up to address some

typical issues e.g. unbundled charges, universal and ADC charges. • The Hong Kong price regulation evolution is a vivid case to illustrate above

discussions.

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Thanks !

Time for questions and comments.

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“I cannot understand the author’s encryption on his PDF documents”

• Sorry for inconvenience!• Now the protections are removed to ease printing and editing.• I used to use protections to secure my copyright.• Please inform me in time (e.g. during the weekend) if you have any

difficulty to read and comment my paper.

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“However, there could have been some advantage and disadvantage analyses concerning how the Price Cap regulation achieves.”

Advantages are already mentioned in the text. • “The regulation places an upper bound on an index of the operator’s price to

restrict the price rather than the profit. Thus, it encourages the operator to reduce cost and to innovate.”

• “In this way, regulators can focus on the whole industry instead of a specific operator in rate-of-return regulation. Thus regulated operators are encouraged to achieve at least below-average cost to gain the benefit of that efficiency.”

There are currently no obvious disadvantages while the complexity to pick up proper factors is high.

• “When applying price-cap regulation formula, the inflation, “X” factor, and time period should be picked up carefully.”

• ”Moreover, profit sharing mechanism can be used as a complementary option to favor customers.”

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“As well as comparison between different kinds of regulations will be nice to be introduced.”

• I have considered this issue while because ” discretionary price and rate-of-return regulation are obsolete”, the necessity is not that high.

• Three regulations are introduced more or less based on the time sequence to show the evolution path of the price regulation. This article is not talking about the different options with their pros and cons so comparison is not obliged in my opinion.

• Disadvantages of discretionary price and rate-of-return regulation are clearly mentioned in the text:– ”This will lead to an unbalanced and inefficient price structure in

economics point of view.” ” all these threaten the viability of operators.”

– ”This violates the efficiency objectives for there is no incentive for operators to reduce their costs. Moreover, it will lead to over-investment, various "cost-padding" activities”

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“The table presented in the paper is nice but to few in any way.”

• Good suggestion!

• My concern is that the article is mainly talking about theory. Papers on economics and regulations do not have so much reading fun compared to other topics presented in this course.

• I tried to avoid use too many lemmas and make this article more vivid. It seems not so successful at least now

• Anyway there is no table in this article . Just a joke

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“However, some 4th approach named by Incentive Regulation is pronounced by other scholars.”

• I do know your exact meaning of “incentive approach”, please cite any scholar’s word regarding this theory.

• In my opinion, price-cap regulation is already an incentive-based approach because “it encourages the operator to reduce cost and to innovate.”

• There are many approaches in theory but quite a few in practice – see next slide

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Incentive regulation mechanisms can be divided into two types: Bayesian and non-Bayesian regulatory mechanisms.

Bayesian mechanism: describe the regulator's lack of information by subjective probabilities, an optimal but lack-applicability mechanism.

The non-Bayesian mechanisms use only observable and variable data and to be independent of the particular regulator. Because those data cannot be foreseen, the mechanisms are not optimal.

Types of incentive regulation have been price caps, rate case moratoria, profit sharing, banded rate-of-return regulation, yardstick regulation, and menus.

Overall, price caps have become the most widespread. It is a blend between Bayesian and non-Bayesian mechanisms. Its main Bayesian parameter is the X-factor, which has to be adjusted every few years

• Rate moratoria can be viewed as the special case of price caps. • Profit sharing regulation has been fading more recently.• Banded rate-of-return regulation requires continuous monitoring of profits and is, thus,

equally• costly in administrative terms as profit sharing.• Yardstick regulation makes the prices the operator can charge dependent on the

performance of other operators. Yardstick regulation is risky for an operator to the extent that its costs differ from the yardstick.

• Menus or options allow the regulated utility a choice among different incentive.

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Thanks for your comment!

Time for more discussions now.