Diversification Incentives under “price-based” and “cost-based” Regulation

1. Diversification Incentives under “price-based” and “cost-based” Regulation By Ronald R. Braeutigam & John C. Panzar Presented by Fadhila

2. Introduction Participation in two markets (regulated and unregulated) • Occurred in connection with regulatory reform of deregulation & divestiture: • Example: AT&T divestiture companies sought to provide: • Basic regulated telephone service • Information service supplied in increasingly competitive market (non-regulated) • Issues: • Enables the company to cross-subsidize in the competitive market • Regulators can not easily structure a fair price taking advantage of economies of scope

3. Cost-Based Vs. Price-Based “Cost-Based” regulation form (combines elements from ROR & FDC) Allocate costs that can be directly and unambiguously attributed Allocate costs that cannot be unambiguously assigned to an individual service using allocation formula For each service, TR=TC “Price-Based” regulation form The firm is regulated by rate caps determined exogenously from the non-competitive market

4. Objective • Models developed w.r.t: • Incentives for cost misreporting • Choice of Technology • Cost-reducing innovation • Choices of prices • Choices of output levels • Diversification into competitive markets To analyze regulation prospect for economically efficient diversification by regulated firms operating under cost-based and price-based form regulations

5. Problem Structure I • Model of regulated firm in two markets: • Market 1 “core market” • Firm operate in a monopoly • Relatively inelastic demand • Y1 is level of output, P1(y1) is the inverse demand for the service • Market 2 “noncore market” • Firm operate in a competitive market as a price taker • Homogeneous service with n number of other identical unregulated firms • Y2 is level of output produced by regulated company, Ye is level of output produced by each other firm • Q = (Y2 + nYe) is total output • Equilibrium at Pe= Ce’’(ye) • Consumer surplus is constant, Producer surplus is zero

6. Problem Structure II Regulated firm cost structure: C(y1,y2) = F + c1(y1) + c2(y2) … (1) Where, F = common cost of production (fixed) ci(yi) = cost of production that can be unambiguously be associated with the production of service i (i=1,2)

7. ROR Regulation I ROR regulation (incentive for cost misreport) Averch & Johnson (1962) key assumption of profit-maximizing firm behavior operates under constraint on the ROR earned on investment is allowed ROR exceeds the actual cost of capital Joskow (1974) suggested that in reality regulators might attempt to allow a return equal to the actual cost of capital In Averch & Johnson model where regulated firms serves two markets (a monopoly and competitive market)a firm might have a long-run incentive to price below LRMC in the competitive market

8. ROR Regulation II • This analysis differs from Averch & Johnson in two aspects: • Similar to Joskow, assume that regulator allows a rate of return equal to the actual cost of capital • A single ROR constraint is imposed to the entire enterprise instead of employing a practice tries to separate monopoly from competitive service in revenue proceeding

9. Cost-Based Regulation Model I • Common allocator functions in regulatory practice include: • Relative quantities f(y1,y2) = y1/(y1+y2); • Relative attributable cost f(y1,y2) = c1/(c1+c2); • Relative revenues f(y1,y2) = R1(y1)/(R1(y1)+Pe*y2) where 0≤f(y1,y2)≤1 • But they assume that regulatory constraint takes the form of: • If the firm wishes to enter into the competitive market, it has to provide a level of output that maximizes the profit π (since it’s a price taker in MKT 2)

10. Cost-Based Regulation Model II The Lagrange multiplier: Where, R1(y1) = y1p1(y1) max. amount of revenue at MKT 1 u1 = waste directly attributed to the core service u2 = waste directly attributed to the noncore service uF = waste characterized as common cost 0<λ<1 implies that u1=0, u2=0, uF=0 Given the technology, the enterprise avoids unproductive inputs An assumption anticipated that a firm can has incentive to choose technology that do not minimize cost (Proposition 2)

11. Choice of output level I • Core Service (no diversification) where: • Point B a firm earns an extra-normal profit • Point E a firm has zero economic profit • Point H a firm price at MC • Noncore Service (with diversification): • Pont A TR = TC (first best where each service priced at MC) • Point G is second best set of output when prices of each service cannot set = MC (Pe* = , π =0)

12. Choice of output level II • On ROR constraint: • Point J is where constraint is optimum and the firm maximizing profit () • At point J, Firm under-produces its service at noncore market to lower the common cost that can be allocated from core market • Proposition 1 “The profit-maximizing firm operating under ROR regulation is Pareto inefficient… The firm choses inefficiently low level of the noncore service. A Pareto superior set of outputs could be obtained by increasing either the level of the noncore service or the levels of both service”

13. Choice of output level III Constraint lies in the negative profit region Allocator function discourage diversification except for point E

14. Choice of Technology Question: Does the firm has an incentive to employ a technology that fails to minimize cost? Generalized the regulated firm cost structure Attributable cost function for each service would have common cost F as the amount spent by the firm on a public input Constrained optimization problem (to minimize TC of output produced ) Proposition 2 “The Profit-maximizing firm operating under a binding ROR constraint may choose an inefficient level of common facilities. It will overinvest (underinvest) in common facilities if, at the margin, the cost reduction such facilities yield for the core service are less than (greater than) the common costs allocated to he core service.”

15. Cost-Reducing innovation Incentive I • Applying envelop theorem on equation (4): • The firm would prefer a cost reduction in the noncore market to a reduction in the common cost • The firm would prefer a cost reduction in the common cost to a reduction in the core service Innovation cost is not addressed • Under ROR incentive to innovate are affected by the way the cost of innovation effort are entered into the constraint. • Four cases on dealing with cost-reducing expenditure: • Case 1: Allocating all to the noncore service • Case 2: Allocating all as common cost • Case 3: Allocating all to the core service • Case 4: Allocate it based on the designed service

16. Cost-Reducing innovation Incentive II • Case 1: Allocating all to the noncore service • The firm would innovate in the noncore market up to the point at which the last dollar's expenditure yields a dollar's cost reduction. • The firm would behave as an unconstrained profit maximizer. • The firm would underinvest in innovation in both common costs and in the core market. • The revenue requirement is decreased as costs fall • No addition to the revenue requirement is made to allow for the cost-reducing expenditures. • The firm will not innovate as much as it would have in the absence of the regulatory constraint.

17. Cost-Reducing innovation Incentive III • Case 2: Allocating all as common cost • Overinvest in noncore market: • Enable it to invest beyond the point at which the one dollar expenditure is just equal to the cost reduction. • Underinvest in the core market: • The last dollar's expenditure would tighten the constraint therefore be unprofitable for the firm • Case 3: Allocating all to the core service • overinvest in common costs and in the noncore market • Case 4: Allocate it based on the designed service • Increases the revenue requirement represented by the regulatory constraint by: • Innovative expenditures attributable to the noncore service • Innovative expenditures which are common • No overinvestment or underinvestment

18. Cost-Reducing innovation Incentive IV Proposition 3. (Cost reducing innovation). “If costs of innovation are treated homogeneously (as in Cases 1, 2 and 3), the levels of innovative effort will generally not be efficient, leading either to underinvestment in cost-reducing innovation in the core market, overinvestment in cost-reducing innovation in the noncore market, or both. If the regulator attempts to allocate expenditures on cost-reducing efforts (as in Case 4), it will have to deal with the incentive the firm will have to characterize such costs as attributable to the core service wherever possible.”

19. Vertical Relationship • Objective: • To show if products are vertically related to one another the previous findings about rate-of-return regulation are unchanged • Profit of the firm will be: • ROR constraint • All the propositions stated holds • Proposition 1: Pareto inefficiency • Proposition 2: Choice of technology • Proposition 3: Cost reducing innovation

20. Pricing below MC ROR constraint The major difference between markets 2 and 3 is that for some reason service 3 is included in the ROR constraint for the firm, while service 2 remains outside that constraint. Proposition 4 “If the regulated firm's activities in a competitive market are included in the ROR constraint, the firm will have an incentive to overproduce; market price will be below marginal cost in such a market.”

21. Diversification Incentive under Price-Cap Regulation I • Price-cap (Price-based): “A regulator sets a ceiling on the rate to be charged in the regulated market; as long as the ceiling is satisfied, the firm can be allowed to enter into and produce whatever output levels it desires in other (non-regulated) markets.” • Economic properties • The firm has no incentive to waste variables u1, u2, & uFdo not enter into a price-level constraint at all. • Incentives to misreport cost allocations and choose an inefficient technology disappear, since cost allocation is not required under this regulatory scheme. • The firm will also have the same incentive to undertake cost-reducing innovation as an unregulated firm • The firm will produce in the noncore market up to the point at which marginal cost equals price. the chosen output will be Pareto efficient. • if the price cap is appropriately chosen, the firm will diversify into a noncore market if and only if diversification is Pareto superior to remaining undiversified

22. Diversification Incentive under Price-Cap Regulation II Core Service (no diversification): At Point E, breakeven point Noncore Service (with diversification): Point M, constrained profit maximizing point Point G, Pareto efficient P1& P2 are unchanged, so movement from E to M does not alter CS

23. Diversification Incentive under Price-Cap Regulation III • Price-cap Problems: • Pareto-efficient market outcomes at point G must be known when the price –cap is set • Too low price-cap will threaten economic viability • Too high price-cap will make ratepayers as losers in the core market • Can the price-cap adequately capture variations in factor prices, general price levels, technology, consumer tastes, and income • can the regulator credibly precommit to a system of price-cap regulation? • What form a price index should take when a firm provides two or more core services

24. Conclusion • The ROR regulation gives the firm: • An incentives to misreport cost allocations, • Choose an inefficient technology (in some cases) • Undertake cost-reducing innovation in an inefficient way • Under produce in a noncore market • Price below marginal cost in a competitive market which happens to be included in the set of core markets regulated by an aggregate ROR constraint • View diversification decisions inefficiently • The Price-cap can induce the firm to: • Minimize costs • Produce efficiently in noncore markets • Undertake cost-reducing innovation • Diversify into a noncore market if only diversification is efficient. • Since cost allocation is not required under Price-cap regulation Incentives to misreport cost allocations and choose an inefficient technology simply disappear,