By: Presented by: D. Mark Kennet Fadhila Al Faraj David J. Gabel

Fully Distributed Cost Pricing, Ramsey Pricing, & Shapley Value Pricing: A Simulated Welfare Analysis for the Telephone Exchange By: Presented by: D. Mark KennetFadhila Al Faraj David J. Gabel

Demonstrates how: • Fully Distributed Cost (FDC) prices, - Ramsey-optimal prices, • Shapely prices, - Standalone prices Can be computed for a variety of baseline output levels using LECOM (Local Exchange Cost Optimization Model) Compares the properties of various public utility pricing schemes in terms of their: • Ability to prevent cross-subsidies • Lead to price structures that are in the core • Minimize welfare losses arising from departures from marginal cost pricing Paper Outline

There are three primary types of facilities found in the local exchange carrier's network: • Local Loop: facilities that provide signaling and voice transmission path between a central office and the customer station. • Switch: connects a customer’s line to either another customer who is served by the same switch or to an interface trunk. • Trunk: carries the calls between central offices. How LECOM operates: • Determine a city dimension and a customer usage level from user data • LECOM search for technological mix, capacity, & location of switches that minimize the annual cost of production. LECOM Model & Data Features I

LECOM Model & Data Features II Ramsey requirement: • Demand elasticity • Marginal & stand-alone costs of different services Hard to implement: • The Interstate Commerce Commission reject it because it requires both marginal cost and elasticity of demand to be quantified which is overwhelming • Fairness issue in allocating prices e.g; multiproduct firm operates in a competitive & non-competitive market, subscribes to the monopoly service art not subsidizing other product • The revenue from the service must be less than its stand-alone cost

LECOM Model & Data Features III - Flat rate: residential customers are connected to the network and are able to make an unlimited number of local calls within their local calling area. - The demand elasticity value is telling us how both demand for access to the network and usage during the peak period declines when the price of flat-rate residential service is increased.

FDC - Objective: to account for principle of recovering cost from the various products that use the input - The relative output approach is to attribute to each output product those costs which can be unambiguously attributed, as well as the percentage of the common and joint cost according to the percentage of the common or joint facility that each service uses Use of LECOM in Computing Pricing Scheme I

Ramsey Pricing to satisfy Where; is the product price, is the quantity is the marginal cost, is I’s own price elasticity Q is the vector of output, is the total cost at the price vector P For simplicity where I represents all products except i Use of LECOM in Computing Pricing Scheme II

Shapley Pricing Objective: "fairness" in the sense that the price is a weighted average of different measures of the incremental value of the service. Shapley prices are computed by: • Arranging all possible orderings of the products of the firm • and then, for the product in question, determine the incremental cost of adding that product to the output vector in that order. • All orderings are assumed to be equally likely, so the average of all the increments is taken to be the Shapley price. Use of LECOM in Computing Pricing Scheme III

Shapley Pricing Since marginal cost pricing is the economic "ideal" in that it maximizes the sum of consumer and producer surplus, the approach is used as a basis for welfare analysis of the other schemes. Use of LECOM in Computing Pricing Scheme IV

There are two allocation rules studied here: • a refers to allocating switched access costs to local and exchange services according to relative usage in the FDC case and allowing the Ramsey rule to determine the allocation in the Ramsey case • b refers to allocating the entire access cost to local exchange in the FDC case and treating it as part of the marginal cost of local exchange in the Ramsey case Results I

Results II

Results III

Summarizing tables I-III data: • How many of the subsidy constraints (including the breakeven constraint) • Each scheme violates in a given city • Adding the ranks across cities to come up with a list of schemes from best to worst according to this notion of weak sustainability The list ranking: • Shapley Pricing & Marginal Cost (tied) • FDC a • Ramsey b & FDC B (tied) • Ramsey a Results IV

Q: What are the welfare consequences in each of the cities simulated by each pricing scheme? A: • Estimate a model of demand for toll exchange service, and uses the estimates of price elasticity of demand for toll service along with outside estimates of price elasticity of demand for local service to analyze departures from optimal pricing. • Simplifying assumption to answer: • No cross-elasticity terms in the demand system for the four telephone services Where is a parameter which we compute by inverting the demand function when price is equal to marginal cost Social Welfare Implementation I

The change in welfare: - Where is the baseline quantity of service t when price is equal to marginal cost is quantity of service t when price is equal to the alternative price By ranking pricing schemes within a city: • From least welfare loss to most • Sum those ranks Results: • Ramsey b • Ramsey a • Shapley, and FDC (tied) Social Welfare Implementation II

Analysis of consumer surplus change relative to the marginal cost baseline shows that while Ramsey pricing maximizes social welfare over the set of schemes considered, only the Shapley approach results in subsidy-free prices. • The welfare loss minimizers are the predicted Ramsey pricing schemes. • Overall best performer in terms of subsidy-free pricing is the Shapley approach where the Ramsey were poor. • FDC pricing is more consistent with the outcome that would be observed were entrants permitted to compete in competitive markets which one of the primary goals of regulation is to emulate the outcome of competitive markets. Conclusion I

As the elasticity of demand was constant, if the model were modified to reflect elasticity increasing with prices, fewer violations would be observed. (lack of information) • Few of the FDC prices were below the marginal cost of service. This suggests that if regulators are to use FDC studies for providing guidance on pricing, they should simultaneously evaluate if the prices exceed the marginal cost of service Conclusion II

By: Presented by: D. Mark Kennet Fadhila Al Faraj David J. Gabel