The Pricing of Inputs Sold to Competitors

1. The Pricing of Inputs Sold to Competitors William J. Baumol J. Gregory Sidak

2. Why do you need to know this??? • BECAUSE YOU KNOOOOWW NOTHING about pricing inputs sold to competitors. You THINK you know…But YOUUU DON’T KNOW!! You know what I [and Baumol ] TELL YOU! • Inspired by an Anonymous ISU instructor … • Now, going forward….

3. Introduction: Identifying the Problem • One of the greatest issues facing regulators of local telephone services is the pricing of access to the local loop. • Difficult due to local exchange carrier (LEC) supplying access to interexchange carriers (IXC’s) while simultaneously competing with them in toll services within a local access and transport area (LATA).

4. Attributes of Access, and associated problems: • “Access” as an intermediate good: It is an input used in the supply of a final product, intraLATA toll service. • LEC produces this input not only by itself, but also by rivals in the market for final product. • Pricing Issues arise: • Firm X being the only supplier of an input used both by itself and by a rival to provide some final product. Firm X can handicap the rivals ability to compete with them if firm X charges more for than input than it charges itself. Distorts efficient division of responsibilities b/t LEC’s and IXC’s in supplying competitive communication services.

5. Magnification of Issue: • If LEC unconstrained by regulation, then they would have the incentive to favor one IXC over another, but more importantly to itself on terms that favor its own competitive position in the intraLATA markets. • Solution: • Requires carefully designed rules on pricing of intermediate inputs such as access, at least until competition is stipulated in access services.

6. Relevant Cost Concepts: • Marginal Cost: • Refers to the increase in the firms’ total outlays resulting from a small rise in the output of X. • Incremental Cost of X: • Generic concept referring to additon, per Unit of additional output in question. MC is estimated by this when the increment is small. • Average Incremental Cost: • Difference in firm’s total cost with and without service ‘X’ supplied, divided by ‘X’: • AICx = [TC(x,y,a…) – TC( 0, y,z…)] /X .

7. Efficient Component Pricing: • Requirement for economic efficiency: • Price of any product be no lower than that products MC or its average-incremental cost. • Must include all opportunity costs incurred by the supplier in providing the product. • The efficient component-pricing rule states simply that the price of an input should equal its average-incremental cost, including all pertinent incremental opportunity costs. That is: • Optimal Input Price= input direct per unit incremental cost + opportunity cost to input supplier of sale of a unit of output.

8. Using a Railroad example to determine the best price under Efficient Component Pricing Rule: Consider two railroads: X and Y, operating along parallel routes from an intermediate point B to a destination C, as seen in the graph to the right. Railroad X owns the only tracks extending from the origin point A to the intermediate point B. Final product is transportation all the way from A to C. Competing railroad Y is also a proprietor of tracks from B to C. Railroad Y can be expected to apply to railroad X to seek rents for interconnection from A to B. If the transaction is completed, the railroad A will be able to ship from A to C and from C to A. Setting a price for access to the local loop in telecommunications is analogous to setting rental fee for track rights.

9. Efficient Component Pricing Rule: Requirement for Economic Efficiency Product –component prices that do not follow this principle create an incentive for inefficiency whose costs consumers have to pay. Therefore, the optimal component pricing rule asserts that rent railroad Y should pay per train is the entire average-incremental cost incurred by each train traversing X’s route AB, including any incremental opportunity costs that Y’s train imposes on X.

10. A brief Illustration: • Suppose the competitive price to shippers for transport from A to C is $10 per ton, and X’s incremental cost along each of its two route segments, AB and BXC is $2 per Ton. Thus, on its carriage of shipments from A to C, X earns a net contribution toward its common fixed costs equal to the final product price minus its two incremental costs: • X’s earned Contribution= $10- $3 - $3= $4 for every ton of freight Train X carries over the full route from A to C.

11. Direct Discussion of the Role of Component Pricing in Promoting Efficiency • Recall previous pricing example of Railroads X and Y, and the rights that Train X must rent to Y in efforts to compete and accrue profit: • We know that the efficient component pricing principle requires that railroad X offer interconnection over route AB to tenant Y at a price equal to ICab plus X’s opportunity cost (that is: $3 + $4 =$7). Railroad Y’s gross earnings per unit of final product will be $3, since the product is sold @ $10 per ton.

12. Continued…Direct Discussion of the Role of Component Pricing in Promoting Efficiency • To determine Y’s net earnings, we must subtract the sum of incremental costs railroad Y incurs when it transports 1 ton of freight over its own route segment to complete the trip from A to C. • Three possibilities: • Case 1: Tenant Y is the less efficient supplier for transport from B to C. • Case 2: Incremental Cost from B to C is equal between both parties. • Case 3: Tenant Y is the more efficient supplier for transport from B to C.

13. Analyzing the different Cases: • Case 1: Y is the less efficient supplier from B to C: • Incremental cost (say $4) exceeds X’s $3. Y will obviously lose money if they attempt to provide final product here. • Case 2: Incremental Costs are identical for both parties from B to C: • Doesn’t matter, as tenant Y will experience NO gain or loss, since profit in incremental capital over BC= $10 -$7- $3=0.

14. Continued Analysis of Different Cases… • Case 3: Tenant is more efficient supplier from B to C: • Presume railroad Y has an incremental cost of $2 per ton from B to C. So as long as the final product is still being sold at or above $10, then the railroad Y can undercut X and make a profit: • Profit= Price of final product- $2-$7. • If the price of the final product is 11$ per ton, for example, then railroad would profit 2$ per ton of the final product sold from A to C. Here, the landlord chooses to buy the final component rather than make the B-to-C transport of the final product.

15. Formal Discussion of the Rule’s Efficiency • Algebraic terms: appropriate per-train payment by the tenant railroad Y (purchaser of Access) is AIC, the per unit incremental cost (not including opportunity costs), plus T/M, where T is the total contribution to common fixed costs that X earned from traffic over route AC prior to granting track rights to railroad Y, and M is the total number of trains of both railroads A to C: • (N) (AIC) + NT/ M= Total payment that X will receive from Y, for Y’s consisting of N trains.

16. Continued Formal Discussion of the Rule’s Efficiency… • This gives X a contribution to profit equal to: • (N)(AIC) + NT/M – cost to X of Y’s traffic over AB= (N)(AIC) + NT/M- (N)(AIC)= NT/M • NT/M is the contribution X receives from Y’s traffic. • X’s contribution from the (M-N) trains of its own after rights are granted is: (M-N)T/M= NT/M. • Therefore, the landlord X’s gain is: • (NT/M) + T- NT/M =T.

17. How Component Pricing Rule Applies: • The Component Pricing Rule (CPR) automatically apportions the task to the most efficient carrier. To see this, we derive a explicit expression for the contribution T of the total traffic over route AC. Let P represent the price shippers pay to transport a trainload of freight over AC. In absence of grant tracking rights to Y, X gets train traffic M by: • T= M(P-AIC-AICx ) ; where AICx is X’s incremental cost if carrying the train the remainder of route BXC.

18. Continued…How Component Pricing Rule Applies… • If Y acquires track rights and sends N trains from A to C, Y will earn a profit equal to its total revenue PN, minus its optimal input price payment, minus (N)(AICy ), the incremental cost incurred by carrying N trains over its own route BYC: • Y’s profits= N(P- AIC- T/M-AICy ) , or substituing value of T/M : • Y’s Profits = N(P- AIC-P + AIC+ AICx -AICy ) = N(AICx - AICy). • Thus Y will profit from renting rights from X if and only if Y is the more efficient carrier, AICy <AICx .

19. Our Application of this rule to Telecom • According to Baumol and Sidak, This rule has been or is likely to be applied in several specific cases: • Clear Communications, Ltd. V. Telecom Corporation of New Zealand, Ltd. (August 1990) • Unlike Telecom, Clear did not have a Kiwi Share Obligation to provide subsidized residential service. A dispute then arose over whether the interconnection fee that Telecom proposed to charge Clear should include a contribution to Telecom’s cost of providing this residential subsidy. • Judge Ellis Ultimately embraced the rule as the appropriate legal standard to guide the pricing obligations imposed on a monopolist that sells inputs to competitors.

20. Controversial Components of Opportunity Cost • Loss of Monopoly mark-up (discourse of pareto efficiency?): • The complaint is that the rule is a means of ensuring that the landlord can continue receiving any monopoly profits it has been able to earn on the final product. By supplying inputs to the tenant, the landlord permits the tenant to take away some profits, which is an opportunity cost to the landlord. The tenant must then compensate the landlord for the loss, ensuring monopoly earnings for the landlord and preventing competitive behavior from the tenant. • Error is failure to impose stand-alone cost ceiling on final product, not efficient pricing rule. The landlord was able to charge monopoly prices from the beginning.

21. More Controversial Components of Opportunity Cost • Special Service Obligations: • When the input supplier is forced to serve as “the carrier of last resort,” therefore forcing them to supply at rates insufficient to cover pertinent incremental costs (like Clear V. Telecom). • Solution: The hypothetical entrant, whose costs constitute the stand-alone cost ceiling, should have imposed on it the same special service obligations as those borne by the incumbent.

22. Annnnnndddd…More…Controversial Components of Opportunity Cost • Network Externalities and Demand Complementarities (didn’t know that was a word): • If the entrant brings in some new customers, it can also stimulate additional demand for the incumbent’s services. For example, more household traffic can stimulate business telephone usage. • Thus, an entering IXC is likely to devote effort to expanding the market, and may even bring in a bit of additional traffic to the LEC.

23. Annnnnnnnnnnnnddd…Mooooorrreeeee…Controversial Components of Opportunity Cost • Marginal and inframarginal Opportunity Cost: • If a firm is a profit maximizer, each of its activities will be carried to the point where it yields zero economic profit at the margin. Thus, opportunity cost of losing the marginal unit of any product due its own activities dissapears like Wesley Snipes during his tax evasion. • However, we should note that scale economies present yet another reason why the opportunity cost incurred by supplying access rivals can not be ignored, as they can effect the cost of an input substantially.

24. ……………. • Entry by Efficient Rivals: • An access charge large enough, at first glance, might seem to convey a competitive disadvantage to the entrant, as it requires an entrant fee plus the variable costs associated with performing the same activities as the incumbent, as the entrant might be even performing these activities inefficiently. • However, the rule presumes that the entrant will be efficient in the supply of their final product, while it ensures that inefficient entrants are not made profitable by an implicit cross-subsidy extracted from the incumbent.

25. Conclusion • As technological innovation and regulatory reform cause entry barriers to fall in the telecom industry, competing firms are seeking to interconnect to the telecom network at a greater number of locations than in the past. • The efficient component pricing rule is applicable generally. The rule “always” assigns the suppliers task to the firm that can do it most efficiently. • Thus, our efficiency result also follows immediately through this indirect route, using the competitive market standard as the guide to efficient pricing.

26. Thank you for Allowing me to bore you!!!!