The Access Pricing Problem

1. The Access Pricing Problem

2. Outline of the Paper • Introduction • Simple Framework: The Margin Rule • Model with Product Differentiation, Variable Proportions and Bypass • Model with multiple inputs and outputs • Conclusion

3. Baumol-Willig Effect • Efficient Component Pricing Rule (ECPR) • Formal Definition: that it is efficient to set the price of access to an essential facility equal to the direct cost of access plus the opportunity cost to the integrated access provider • Optimal access charge = direct cost of providing access + opportunity cost of providing access

4. And so… • The purpose of the paper is to analyze the meaning of opportunity cost (that is, the definition of opportunity cost in the B-W effect) under supply and demand conditions to determine access pricing benchmarks

5. A simple framework: the margin rule • Set up: • Single final product • Two firms: • Incumbent (the incumbent is assumed to have control over (monopolize) access) • Entrant • Supply: access • Assumed based on natural monopoly

6. Definition of terms • I – incumbent firm • C(q,z) • Cost incurred by I when it supplies q units of z (access) to E (the entrant) • C2 is I’s direct marginal cost of providing access to E • C1 is I’s marginal cost of providing the final product to consumers • The Entrant: • Requires one unit of access from I for each unit of the final product they supply

7. Now… • Let’s suppose • E has s units of access • It incurs an additional cost, c(s) , to supply s units of final product • Assumption: • E has no fixed cost of entry, making c(0) = 0 • Marginal cost denoted c’ • Uniform access pricing is assumed and the access charge per unit of the input is defined as: a • P is the Incumbent’s price for the final product

8. TC = as + c(s) • Entrant has a maximum possible profit given the available margin: • Available margin: m= p – a • Profit function • π(m) ≡ max: ms – c(s)

9. Some conditions • s(m) < X(P) • Where X(P) is the consumer demand function for the final product • v(P) is consumer surplus • Where v’(P) ≡ - X(P)

10. And so, the incumbent’s profit for the final product P and margin: m = P – a • Π (P, m) ≡ PX(P) – ms(m) – C(X(P)) – s(m), s(m)) • And so, the measure of total welfare W(P,m) ≡ v(P) + π(m) + Π(P,m)

11. The welfare maximizing for of pricing for the incumbent’s products (including access) subject to a break-even constraint for the incumbent……. • Note: • λ ≥ 0 as a multiplier for the constraint Π≥ 0

12. A special case of these Ramsey formulae : • Break even constrain does not bind, so θ = 0 • Making P = C1 • Meaning: • If the incumbent’s cost function is such that setting all prices (including access) = MC does not result in the firm making a loss • This is socially optimal • This is first best access pricing policy

13. If θ > 0 • Incumbent has increasing returns to technology • Break even constraint will not bind at social optimum • Thus, the Lerner index is positive: • a > P – [C1 – C2] > C2 • Optimal to set access prices greater than MC of providing access

14. Now…since this form of access pricing is not done by regulators, we have to consider the practical importance that • Optimal access pricing: assuming some fixed and some type of retail tariff imposed by the incumbent • This abstracts from the issues of allocative efficiency

15. Suppose: • P, price for the final product, is fixed by regulation •  X(P), quantity demanded is also fixed • Fixed retail tariffs • a = [C2] + [P – C1] • Which implies that θ = 0 • This optimal charge is consistent with the ECPR

16. With contestability, the entrant’s elasticity of supply ηs is zero • In the simple marginal rule, • P – a should be equal to [C1 – C2] • THUS: ECPR = Marginal Rule

17. Conclusions • Optimal to set the access charge greater than direct-plus-opportunity-cost price if the incumbent’s break even constraint is binding • The markup over ECPR benchmark is inversely related to the elasticity of demand for access