Pricing Principles & Practices in Competitive Circumstances By Patrick Xavier School of Business Swinburne Universit

1. Pricing Principles & Practices in Competitive CircumstancesBy Patrick XavierSchool of BusinessSwinburne University, Melbourne ITUWorkshop(1)

2. Traditional pricing Cross-subsidisation for political, social etc., reasons resulting in high prices for international and long-distance service subsidising low (below cost) prices for connection and local service

3. Traditional pricing Cross-subsidisation not sustainable under competition since services with high profit margins will be vulnerable to competitive entry.

4. Profit margin PRICE__________________________ COST___________________________

5. Pressure to re-structure prices To reduce scope for competitors to under cut TOT’s price, there will be pressure on TOT to cut international and long distance prices.

6. Falls in prices in Australia • Telstra’s national long distance call prices fell by about 30% in real (inflation-adjusted) terms between 1995 and 1999. • Telstra’s international call prices fell by about 60% in real (inflation-adjusted) terms between 1995 and 1999. • Calls from fixed to cellular mobile fell by about 30% (largely in 1999) although a flagfall of 15 cents per call was introduced.

7. Pressure to re-structure prices • In order to maintain revenue, there will be pressure to increase the prices of currently cross-subsidised prices.

8. Re-structuring prices Other areas of price restructuring towards prices becoming “cost-based” or cost-oriented” can include: • urban/rural • upfront (flagfall) component/useage • peak/off-peak • wholesale/retail • price discounts

9. Appropriate costs upon which to base prices not easy to identify • Identification of appropriate costs is not easy. • Until the cost systems are in place, TOT can benchmark the price restructuring that is occurring in other markets that are becoming increasingly competitive. • Even when cost information is available, benchmarking will provide a “reality check”.

10. Pressure on TOT to reduce costs • It is not enough simply to base prices on current costs. • This is because prices based on costs that are inefficiently high will also provide opportunity for competitive entry by more cost-efficient rivals. • So in competitive circumstances it will be necessary to keep costs as low as possible.

11. Pressure on TOT to reduce costs • Another reason to cut costs is that with prices falling, cutting costs will be a means of helping to maintain profit margins and overall rate of return on assets.

12. Maintaining profit margin PRICE__________________________ COST___________________________

13. Profit levels • The level of profit becomes increasingly important with commercialisation, privatisation and competition. • Benchmarking can help establish appropriate profit targets for TOT

14. Cutting costs to maintain margins and overall profit • This is one reason for the considerable cost cutting many telecommunications operators have been (and are) engaging in.

15. The “floor level” of prices • In fact, the “floor level” below which prices should not be set are in principle not current costs but efficient costs, including the use of best technology.

16. Long run incremental cost (LRIC) • This concept of efficient costs is the rationale of “forward-looking” LRIC.

17. Long run incremental cost (LRAIC) • Important to understand this concept of costs because the regulatory agency will probably follow what is happening overseas and require TOT to apply LRIC in pricing decisions, especially regarding Interconnection and also “unbundling” of network elements. • But more on this in a later presentation.

18. Wholesale/retail pricing New entrants have frequently complained of being “price squeezed” by incumbent telecommunications operators that supply end-user service as well as access/interconnection service.

19. Price squeeze Retail__________________________ Wholesale______________________

20. Price squeeze So for competitive reasons, TOT might consider such competitive tactics.

21. Price reductions that increase total revenue • To limit revenue loss, the price reductions can be selective and restricted to only some services. • However, price reductions can result in an increase in total revenue where demand is “price elastic” ie. responsive to a price change. So there is need for TOT to better understand demand elasticities for various types of services.

22. Price reductions that increase total revenue • Price reductions to boost “loyalty” can also increase revenue. • One common approach that has been accelerated by competitive pressure is price discount schemes.

23. Price discount schemes • Price discount schemes can be used to boost loyalty and to target selected market niches. • They can be used to retain/attract high-value customers.

24. Price discount schemes The range of price discount schemes for PSTN services includes discounts on: • connection charges • rental payments • ‘non-traditional’ time of day/week discount schemes, such as ‘every third minute free’ for off-peak calls

25. Price discount schemes • local calls • national long distance • international

26. Price discount schemes • call duration • for a fixed charge, talk ‘for as long as you like’ on national & international calls • ‘friends & family’ calling-circle discounts on calls to a number of pre-specified frequently called numbers

27. Price discount schemes • discounts that vary with the size of the customers bill • discounts based on customer loyalty, including the customer’s willingness to use the supplier exclusively • discounts that vary with the term of the contract signed.

28. Price discount schemes Customer response to discount schemes can generate important information about demand sensitivities that can assist the development of pricing strategies.

29. Price discount schemes • Discount schemes may also generate useful information for acquisition of customers rather than simply traffic. • This will be important as competitive strategies turn to the development of core markets for high-value and data-based products that go well beyond the simplest forms of price competition.

30. Price discount schemes In common use are price discounts that vary with the size of subscription charges required for participation in the discount scheme. Such discount schemes can significantly increase revenue while encouraging loyalty, since customers want to maximise the benefits from their subscription.

31. Benchmarking discount schemes • TOT could find it valuable to benchmark and analyse price discount schemes used overseas, including the results of such schemes on revenue and competitive objectives.

32. Price discount schemes complicate international benchmarking of prices • Note that because the nature, scope, number of beneficiaries and depth of price discount schemes vary among countries this complicates international benchmarking of telecommunications prices.

33. Cross-subsidisation for competitive reasons In some countries, price competition has tempted the incumbent former monopoly to cross-subsidise the prices of services for which there is strong competition. Revenue from high prices for services for which there is no (or relatively less) competition is used.

34. Regulation & Cross-subsidisation This would seem an attractive competitive strategy but will almost certainly be prohibited by regulation which is likely to prescribe: • a “floor” level based on LRIC (below which prices are not permitted to fall) • a “ceiling” level based on “stand-alone costs” (above which prices cannot go)

35. Regulation & Cross-subsidisation • TOT should prepare itself for the expected “negotiations” with the regulator by arming itself with information relating to cost-based price ‘floors’ and ‘ceilings’.

36. Regulation & Cross-subsidisation • Benchmarking movements in price levels and structures of incumbent operators in markets experiencing increasing competition will provide valuable information for pricing strategy as well as for negotiations with the regulator.

37. Interconnection charges in competitive circumstances • As noted earlier, for competitive reasons TOT might wish to adopt a ‘price-squeeze’ strategy with price reductions on the one hand and ‘high’ interconnection charges on the other. • The high interconnection charges could also serve to compensate for reduction in revenue from falling retail prices.

38. LRIC and Interconnection Prices • However, a regulator-imposed obligation to apply LRIC or price cap regulation could restrict efforts to increase wholesale interconnection price. • Another constraint on high interconnection prices is that this would provide more incentive for new entrants to quickly install their own infrastructure.

39. LRAIC and Interconnection Prices • TOT should equip itself for the expected “negotiations” with competitors and with the regulator by installing cost accounting systems that would enable it to obtain the required cost information.

40. Benchmarking can help • Benchmarking interconnection prices in other countries could also generate useful information both for developing competitive strategy and for use during ‘negotiations”.

41. Price of “unbundled” network elements • Another potential major issue TOT might face relates to the price of “unbundled” network elements, including ADSL enhanced segments of the network.

42. LRIC and “unbundling” • It now seems increasingly widely accepted that the price of “unbundled network elements” of the local loop should also be based on LRIC. • In Canada, the obligation to allow access will be only for five years. • In the Netherlands, the price is to be initially LRIC but then be raised over five years to a commercial rate.

43. Other areas... • Other areas where benchmarking will be useful are leased lines, and pricing of Internet use.

44. Reference Patrick Xavier, “Price setting and regulation for telecommunications in the absence of reliable and detailed cost information”, Telecommunications Policy , 1997.Volume 21, No.3, pp.213-233.