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Interconnection pricing
Telecommunications Policy 1994 18 (5) 414-420
Interconnection pricing An analysis of the efficient component pricing rule
Robert Albon
A potential entrant wishes to offer a long-distance service by establlshlng Its own long-distance ‘upstream’ faclllty and ualng the Incumbent’s local (‘downstream’) network to provide retlculatlon of lts calls, and the Issue Is to determlne an effklent lnterconnectlon price for the entrant’s use of that faclllty. Wllllam Baumol has proposed the ‘efflclent component prlclng rule’ (ECPR) which Is developed using a slmpllfled rallroad example. The efflclent component price Includes both lncremental costs and overheads. Analysls of flclent lnterconnectlon pricing revolves around the deflnltlon of incremental and ‘overhead’ costs, and It Is concluded that the ECPR does not provide an efflclent basis for lnterconnsctlon pricing. Dr Robert Albon may be contacted at the Department of Economics, The Faculties, Australian National University, Canberra, ACT 0200, Australia (Tel: +61 6 249 4466; fax: +61 6 249 5124). I am grateful to an anonymous referee for useful suggestions, to Martin Cave for information on the ECPR and comments on an earlier draft, and to participants at seminars at Keio, Niigata and Osaka universities. Of course, I am entirely responsible for the contents of the paper. ‘Perhaps naively, it is assumed that the sole objective is to set an efficient price. Obviously actual determinations of interconnection prices involve factors other than economic efficiency. For example, governments often seem to consider the political repercussions of the resulting pricing structure for services. continued on page 4 15
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The problem analysed in this paper is one where a vertically integrated firm - the incumbent - offers two services, one using both the upstream and downstream segments of its production facilities, the other using only the downstream part. Telecommunications provides an obvious example, with long-distance and local calls being the respective services. We assume that the incumbent initially has a statutory monopoly overall, but a natural monopoly on only the downstream segment. A potential entrant wishes only to compete on the service using both segments, and proposes to do this by establishing its own upstream facility and interconnecting with the incumbent’s downstream facility to provide the service. The incumbent possesses a facility essential for the rival to enter. The issue is to determine an efficient price for the entrant’s use of the essential facility - that is, to determine an efficient price for interconnection.’ One proposal, associated with William Baumol, is for application of what he calls the ‘efficient component pricing rule’ (ECPR).2 The ECPR approach involves charging the interconnecting party for both the incremental cost (including incremental capital cost) of using the segment of the incumbent’s network, and the overhead contribution forgone. Interest in this rule is not totally academic. Something like the ECPR has been used in the UK. This is clear from the following condition contained in British Telecom’s licence: . . .that the operator pays to the licensee the cost of anything done pursuant to or in connection with the agreement including fully allocated costs attributable to the services to be provided and taking into account relevant overheads and a reasonable rate of return on attributable assets. This approach has been reaffirmed in the recent interconnect policy determination by the Office of Telecommunications (Oftel). The purpose of this short paper is to determine whether this rule is an efficient basis for interconnection. The main task is to formalize and assess a simple railroad example discussed by Baumol. However, as discussion of interconnection revolves around - but is not exclusive to -
030%5961/94/050414-070 1994 Butterworth-Heinemann Ltd
Interconnection pricing: Robert Albon telecommunications, we look at how this industry conforms with the conditions of the problem examined both before and after considering the railroad example.
The telecommunications
continued from page 4 14 ‘Baumol’s views have been presented in a number of places including W.J. Baumol, ‘Modified regulation of telecommunications and the public interest standard’, mkneo, undated; W.J. Baumol, ‘The benefits of competition’, Financial Times, 10 April 1991; and W.J. Baumol and RD. Wfflig, ‘Brief in evidence: economic principlea for evaluation of the issues raised by Clear Communications Ltd on interconnection with Telecom Corporation of New Zealand Ltd’, mimeo, 1991. Vhe need for an interconnect policy goes back to the beginning of telephony; see, for example, the fascinating paper by A.N. Hdcombe, ‘The telephone in Great Britain’, Quarterly Journal of Economics, Vol 21, No 5, 1906, pp 96-135. 41ndeed,it has been argued (eg S. Vickers and G. Yarrow, Privatization: An Economic Analysis, MIT Press, Cambridge, MA, 1966, pp 69-76) that a ‘generous’ interconnect policy is efficient under some circumstances as an offset to uncompetitive elements in the existing arrangements. Some of the problems with Australia’s pricing structure.prior to competition are considered in R.P. Albon. ‘The welfare costs of the Australian telecommunications Pricing structure’, Economic Record, Vol -4, No 165. June 1966. DD 102-l 12. Like manv other countries’ .teiecommunications pricing structures, Australia’s was - and to some extent remains - inefficient in three major respects. First, long-distance prices are far too high, and the huge mark-up on costs cannot be given a Ramsey-Boiteux justification. Second, local call prices are too low in the peak period. Third, access charges are too low and insufficiently differentiated by cost of connection or users surplus.
network and its usage
The overall telecommunications network comprises three distinct but related sections: the customer access network (CAN), the local network, and the long-distance (or ‘trunk’) network. The CAN is the system of dedicated links (usually a pair of copper wires) which join customers to their nearest telephone exchange. The local network is the system of local telephone exchanges and the local trunks which link the different exchanges with each other. The local network in a particular region will feed in to a gateway exchange. The different gateway exchanges and the trunks linking them (which may be optic fibre, microwave, satellite or some earlier medium) form the long-distance network. Of course, the dividing lines between the different parts of the overall network may be somewhat ambiguous. Competition in the telecommunications network does not usually involve a rival completely duplicating the network of the incumbent. This may be a consequence of natural monopoly elements, especially in the CAN and local network. Accordingly, new carriers have usually established their own long-distance network (sometimes only on the ‘thicker’ routes) and have interconnected into the incumbent’s local network (and CAN) at the point of gateway exchanges. This gives rise to the need for an interconnection policy determining the conditions and price of access to the first carrier’s transmission and switching facilities3 It is assumed that the aim of this policy is to achieve an efficient outcome. The ‘need’ for a second (or third or fourth) carrier is not obvious to some observers. In the circumstances where the incumbent prices efficiently and produces in a technically efficient manner, it is easy to imagine that no entry would occur unless interconnection were allowed on very favourable (‘sub-economic’) terms. Such entry would not be socially desirable. Alternatively, in these circumstances any pricing structure which correctly mirrored the shadow price of interconnection would be prohibitive. On the other hand, dissatisfaction with the performance of existing monopoly operations and frustration with the results of traditional regulations have led to calls for competition. Indeed, in many countries network competition has flourished - some would argue as a consequence of generous pricing of interconnection, but more likely as a consequence of existing pricing and cost structures being inefficient and economies of scope being either negligible or small relative to the effects of price and cost inefficiencies.4 Two underlying principles appear to be common to determination of interconnect policy in different countries. Firstly, the local network (including the CAN) has been regarded as an essential facility which must be open to rivals for competition to be ‘successful’. Secondly, governments have not allowed incumbent carriers to determine the price and conditions of access to the essential facility. Bodies like the Federal Communications Commission (FCC) and Oftel have assumed regulatory roles, presumably to prevent monopoly pricing of interconnection. However, the approaches taken have been varied, in most
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cases without explicit regard to the significant input potentially available from public utility pricing principles.5
The efficient component pricing rule (ECPR) Baumol has proposed the following rule for pricing of services supplied by one company to another: ‘A company in a free market which voluntarily rents facilities to another company will do so only if the rental fee is high enough to offer the renter at least as much profit as it could earn by employing the facility itself.’ This becomes the ECPR when the renter is viewed as offering a component in a production chain. Baumol and Baumol and Willig use the example of a railroad offering a journey from A to C which is produced in two components A-B and B-C. The incremental cost of each leg is $3 but the railroad covers its overheads with a contribution of $4 per journey from a price of $10 per journey. The ECPR would dictate that an operator wishing to offer an alternative service using the existing railroad for the A-B segment of the journey and its own facilities for B-C should be charged $7 ($3 incremental cost plus $4 lost contribution to overheads per rival journey). There are several possible definitions of both incremental cost and overhead cost, so it is useful to begin with those stated by Baumol and Willig. Firstly, incremental cost comprises any variable costs attributable to the carriage of the interconnector’s traffic, plus it ‘includes the required profit on any required incremental investment, that is, the cost of the required capital’.6 Overhead costs are ‘the common fixed costs which do not enter the incremental costs of the individual products’.’ There is some ambiguity with both definitions when viewed in the light of the railroad example where, first, no incremental investment would be required and, second, there is only one product (the A-C service). Other cost definitions and interpretations will be introduced later. Baumol and Willig make strong claims for the ECPR. In particular, they assert that ‘it always assigns the supplier’s task to the firm that can do it most efficiently’.* They argue against a lower price for interconnection on the grounds that it is ‘always an invitation to inter-firm cross-subsidy” and that ‘it can lead to entry that raises social costs’.10 We now attempt to assess these claims in the light of, first, the railroad example, and second, the circumstances of telecommunications.
The railroad example 5The classic paper by A. Hazlewood, ‘Optimum pricing as applied to telephone service’, tieview of Economic Studies, Vol 18, 1958-51, PD 87-78 IreDrinted in Pt. Turvey, ed, .Piblic Econ~mks, Penguin, Harmondsworth, UK, 1988, pp 237-257), is still an excellent account of efficient Drinciples for telecommunications pricing. S.J. Brown and D.S. Siblev. The Theorv of Public Utility Pricing, Cambridge Univeky Press, Cambridge, UK, 1988, provide a more modem account. 6Baumol and Willig, op tit, Ref 2, p 31. ‘ibid, p 31. ‘Ibid, p 35. ‘Ibid, p 35. “Ibid, p 37.
416
To consider this example further we must place a little more structure on the problem. Consider a case (Figure 1) where the incumbent’s incremental cost of each leg, MCAB and MCsc, are each invariant with output, and the incumbent has overheads of F; yielding average total cost: ATC = MCA, + MCBc + F/Q.
(1)
Market demand for the whole journey is D. The efficient price consistent with cost recovery is P* with quantity Q*. We also assume that the entrant has its own overhead costs. That is, we assume that overheads relate to the provision of the service, not to the operation of the stages. This seems to be the only sensible assumption that can be made in these circumstances. In the railroad
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Policy 1994 Volume 18 Number 5
Interconnection pricing: Robert Albon
Figure 1. Framework for considering Baumol and Willig’s railroad example of their ECPR rule.
QM
Q*
b Q
example there is only one service (A-C) and there will only be one operator (the incumbent or the potential entrant). If the entrant is successful, the original service provider will only operate the A-B stage of the journey and will have no ‘overheads’ - only costs relating to A-B. Consider first the case where the incumbent is cost efficient in its operations and prices on the basis of cost recovery. In these circumstances, assume that an interconnector with the same cost structure wished to offer the A-C service, using the existing carrier for the A-B segment. Under the ECPR the following interconnection charge would be set: MCAB+ F/Q*
(2)
P* - MCBc
(3)
or
The aspiring entrant could not possibly enter as it would have to charge a price of at least P*, plus its own unit overheads. This is the socially efficient outcome because the first carrier is doing the best possible, and driving it out and replacement with an identical carrier is futile. The ECPR passes this simple efficiency test. Now assume the incumbent is efficient in costs but initially prices at the monopoly level PM, with quantity Q”. With the ECPR, and where the potential entrant would have the same overheads, the aspirant could only begin forcing a more efficient price where the existing carrier’s per-unit profits exceeded its per-unit overheads, ie where
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where i) is the break-even price at the monopoly output. The extent of any possible efficiency gain is limited by this excess. The ECPR in this circumstance may achieve an efficiency gain but it cannot possibly force the efficient solution. It fails our efficiency test: the ECPR is unable to result in the elimination of monopoly profits by an existing operator. Consider now the case where the incumbent does not exploit its monopoly power but is inferior in cost on the B-C leg, having a marginal cost of MC B,-, greater than that of the aspirant, MC’B~ Society would benefit from having the new carrier operate the route (and the whole service). The ECPR would dictate a price for interconnect of P* - MCigc,meaning that the aspirant could only enter if MC”BC +F=/Q+
MCiA,+F'lQ
(5)
Making the assumption that incumbent and entrant have the same average overheads, substituting in for the components of the incumbent’s costs, and rearranging yields the condition for possible entry in terms of the incumbent’s cost disadvantage:
FlQ<(MC&,-MC'&.
(6)
Clearly there are many circumstances where this will not hold in spite of the entrant having a clear cost advantage, and, indeed, circumstances where it could not possibly hold. In this regard, note that Baumol and Willig’s numerical example would preclude the possibility of entry as
MCzB,>FIQ*
I’M. Cave, ‘Inter-connection pricing’, mimeo, Brunel University,June 1991.
418
(7)
ie even if the aspirant could do B-C for nothing, the cost advantage would be less than the necessary overhead contribution of $4. Assume now that the potential entrant has an advantage on overhead costs. Even if the advantage were absolute (that is, the entrant had zero overheads) it could not equal the existing carrier’s costs after effectively paying for its inefficiency. Obviously the ECPR fails in this case, as it is inconceivable that the potential entrant could have zero overheads, much less negative ones. Cave’s modification of the rule to cover these situations - ‘interconnection charges should be paid at incremental cost plus contribution, where both of these are based upon the data of an efficient operator”’ does not appear to be adequate to redeem the ECPR. Not only is it ‘clearly difficult to implement’ (because the market process is necessary to find efficient operators) but it is also merely the lowering of what will still be an unclearable hurdle (in the case of overheads) or at least a very high one (in the case of the incremental cost). So far we have assumed that overhead costs apply to the whole service, A-C. While this seems to be the natural assumption, at no point do Baumol and Willig mention or imply the possibility of an entrant having overhead costs. It would appear reasonable to assume that they believe that overhead costs for the entrant on operating B-C are zero. It follows that, if the entrant’s overheads for B-C are zero, they should also be zero for the incumbent. This in turn implies that ‘overhead costs’ relate only to the A-B route, and are not really overheads at all. Rather, they are costs which are allocatable to the A-B stage. It is beyond any dispute that an entrant should be charged the incremental cost of its use of the A-B route. However, rather than Baumol and Willig’s definition of incremental cost, the appropriate
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concept of incremental would appear to be:
cost of the A-B stage in these circumstances
C(QAB, QBC)- W, QBC). With this definition of incremental should be set equal to: PAB
=
(8) cost, price for the interconnector
[~(QAB, QBC) - C(O, QBC)I/QAB
(9)
In the simple example of the railroad, this would give the same answer ($7) as Baumol and Willig get, but through very different reasoning.
Application in telecommunications
‘%aumol, op tit, Ref 2, p 27. %I determining actual prices for the local network the concept of incremental cost must account for differences in peak and off-peak costs. These and other factors are considered in R.P. Albon, ‘Interconnection pricing: peak and off-peak considerations’, mimeo, Australian National University, January 1994.
There are several differences between Baumol and Willig’s railroad example and the circumstances in telecommunications as set out earlier in this paper. All of these place the ECPR in a different perspective from the railroad example. Perhaps the most important of these differences are the following. First, real-world entrants into long-distance markets do not take over the entire service. Indeed, they often appear to develop existing sub-markets and to establish new niche markets. Even if overheads were definable and were to be charged to the entrant, only those pertaining to the incumbent’s absolute loss of market are applicable to the entrant. Second, the A-B stage in telecommunications is not just a component in a production process, but also a separate service - that is, local service. This service will make its own contribution to any unallocable overheads, and this will also reduce the charge attributable to the interconnecting party. Third, in telecommunications there is a third stage - the customer access network - which has its own charging basis. Given the extreme inelasticity of access demand, the contemporary approach to telecommunications pricing would seek to place the entire burden of any unattributable overheads on an appropriately devised structure of access charges. Fourth, it is difficult to conceive of what significant unattributable overheads in telecommunications there might be. It should be possible to allocate nearly all costs to particular services. This seems to be conceded by Baumol in his paper discussing interconnection issues surrounding British Telecom: ‘a substantial proportion of BT costs (. . . 80 to 85 per cent . . .) seems to be separable and causally attributable to the individual services responsible’. ‘* The efficient overall solution in telecommunications would seem to lie in the incumbent attributing costs to each stage correctly and charging an efficient price based on incremental cost (as defined at the end of the previous section) at each stage. This would result in complete or almost complete cost recovery. To the extent that there are any unattributable costs, these should be charged to access. In the case of the local network, all uses of it should be charged on the same basis, including the incumbent charging entrants (and itself) the incremental cost of its own use of the local network to connect long-distance and international calls. l3 There is one caveat to this conclusion. Rectifying existing inefficiencies in pricing may not be totally at the discretion of the incumbent. Where, for example, an incumbent is prevented by regulation from
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charging efficient prices for local service - as in Japan and the USA, for example - the entrant should be made to pay the true incremental cost, and perhaps bear a share of the cost of the incumbent’s subsidies.
Conclusions The emphasis in this paper has been on the appropriate rule for the interconnection of competing networks in industries such as telecommunications. There has had to be some preliminary discussion of the issue as to why the government would want to allow interconnection at all. Perhaps the strongest reason is that governments have not been very successful in getting monopolistic telecommunications carriers to behave in socially efficient ways. This, when combined with natural monopoly in at least one segment of the production process, provides a potent case for facilitating competition through an interconnection approach. In arguing for the efficient component pricing rule in telecommunications, Baumol has used the example of a railroad producing one output in two stages. A successful entrant would take over the running of the whole service. In this example, overheads have one of two interpretations - either they attach to the provision of the service or they attach to the A-B stage. In the first case the entrant would, in taking over the service, assume the overheads, and the ECPR is inappropriate. In the second case the overheads are, in fact, part of the cost of operating A-B, and should be reflected in its incremental cost. Again the ECPR is inappropriate. Turning then to the conditions in telecommunications, these are obviously very different from those in the railroad example, and the ECPR is not necessarily applicable here even if it were for the railroad. Indeed, it appears to be inapplicable in telecommunications. In particular, telecommunications costs seem to be largely ‘separable and causally attributable’, and to the extent that they are not, any overheads should be retrieved from service access charges. A properly defined incremental cost rule is appropriate. Where the incumbent is constrained to price inefficiently, a different prescription for the interconnection price may emerge.
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Telecommunications Policy 1994 Volume 18 Number 5
Interconnection pricing An analysis of the efficient component pricing rule
Robert Albon
A potential entrant wishes to offer a long-distance service by establlshlng Its own long-distance ‘upstream’ faclllty and ualng the Incumbent’s local (‘downstream’) network to provide retlculatlon of lts calls, and the Issue Is to determlne an effklent lnterconnectlon price for the entrant’s use of that faclllty. Wllllam Baumol has proposed the ‘efflclent component prlclng rule’ (ECPR) which Is developed using a slmpllfled rallroad example. The efflclent component price Includes both lncremental costs and overheads. Analysls of flclent lnterconnectlon pricing revolves around the deflnltlon of incremental and ‘overhead’ costs, and It Is concluded that the ECPR does not provide an efflclent basis for lnterconnsctlon pricing. Dr Robert Albon may be contacted at the Department of Economics, The Faculties, Australian National University, Canberra, ACT 0200, Australia (Tel: +61 6 249 4466; fax: +61 6 249 5124). I am grateful to an anonymous referee for useful suggestions, to Martin Cave for information on the ECPR and comments on an earlier draft, and to participants at seminars at Keio, Niigata and Osaka universities. Of course, I am entirely responsible for the contents of the paper. ‘Perhaps naively, it is assumed that the sole objective is to set an efficient price. Obviously actual determinations of interconnection prices involve factors other than economic efficiency. For example, governments often seem to consider the political repercussions of the resulting pricing structure for services. continued on page 4 15
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The problem analysed in this paper is one where a vertically integrated firm - the incumbent - offers two services, one using both the upstream and downstream segments of its production facilities, the other using only the downstream part. Telecommunications provides an obvious example, with long-distance and local calls being the respective services. We assume that the incumbent initially has a statutory monopoly overall, but a natural monopoly on only the downstream segment. A potential entrant wishes only to compete on the service using both segments, and proposes to do this by establishing its own upstream facility and interconnecting with the incumbent’s downstream facility to provide the service. The incumbent possesses a facility essential for the rival to enter. The issue is to determine an efficient price for the entrant’s use of the essential facility - that is, to determine an efficient price for interconnection.’ One proposal, associated with William Baumol, is for application of what he calls the ‘efficient component pricing rule’ (ECPR).2 The ECPR approach involves charging the interconnecting party for both the incremental cost (including incremental capital cost) of using the segment of the incumbent’s network, and the overhead contribution forgone. Interest in this rule is not totally academic. Something like the ECPR has been used in the UK. This is clear from the following condition contained in British Telecom’s licence: . . .that the operator pays to the licensee the cost of anything done pursuant to or in connection with the agreement including fully allocated costs attributable to the services to be provided and taking into account relevant overheads and a reasonable rate of return on attributable assets. This approach has been reaffirmed in the recent interconnect policy determination by the Office of Telecommunications (Oftel). The purpose of this short paper is to determine whether this rule is an efficient basis for interconnection. The main task is to formalize and assess a simple railroad example discussed by Baumol. However, as discussion of interconnection revolves around - but is not exclusive to -
030%5961/94/050414-070 1994 Butterworth-Heinemann Ltd
Interconnection pricing: Robert Albon telecommunications, we look at how this industry conforms with the conditions of the problem examined both before and after considering the railroad example.
The telecommunications
continued from page 4 14 ‘Baumol’s views have been presented in a number of places including W.J. Baumol, ‘Modified regulation of telecommunications and the public interest standard’, mkneo, undated; W.J. Baumol, ‘The benefits of competition’, Financial Times, 10 April 1991; and W.J. Baumol and RD. Wfflig, ‘Brief in evidence: economic principlea for evaluation of the issues raised by Clear Communications Ltd on interconnection with Telecom Corporation of New Zealand Ltd’, mimeo, 1991. Vhe need for an interconnect policy goes back to the beginning of telephony; see, for example, the fascinating paper by A.N. Hdcombe, ‘The telephone in Great Britain’, Quarterly Journal of Economics, Vol 21, No 5, 1906, pp 96-135. 41ndeed,it has been argued (eg S. Vickers and G. Yarrow, Privatization: An Economic Analysis, MIT Press, Cambridge, MA, 1966, pp 69-76) that a ‘generous’ interconnect policy is efficient under some circumstances as an offset to uncompetitive elements in the existing arrangements. Some of the problems with Australia’s pricing structure.prior to competition are considered in R.P. Albon. ‘The welfare costs of the Australian telecommunications Pricing structure’, Economic Record, Vol -4, No 165. June 1966. DD 102-l 12. Like manv other countries’ .teiecommunications pricing structures, Australia’s was - and to some extent remains - inefficient in three major respects. First, long-distance prices are far too high, and the huge mark-up on costs cannot be given a Ramsey-Boiteux justification. Second, local call prices are too low in the peak period. Third, access charges are too low and insufficiently differentiated by cost of connection or users surplus.
network and its usage
The overall telecommunications network comprises three distinct but related sections: the customer access network (CAN), the local network, and the long-distance (or ‘trunk’) network. The CAN is the system of dedicated links (usually a pair of copper wires) which join customers to their nearest telephone exchange. The local network is the system of local telephone exchanges and the local trunks which link the different exchanges with each other. The local network in a particular region will feed in to a gateway exchange. The different gateway exchanges and the trunks linking them (which may be optic fibre, microwave, satellite or some earlier medium) form the long-distance network. Of course, the dividing lines between the different parts of the overall network may be somewhat ambiguous. Competition in the telecommunications network does not usually involve a rival completely duplicating the network of the incumbent. This may be a consequence of natural monopoly elements, especially in the CAN and local network. Accordingly, new carriers have usually established their own long-distance network (sometimes only on the ‘thicker’ routes) and have interconnected into the incumbent’s local network (and CAN) at the point of gateway exchanges. This gives rise to the need for an interconnection policy determining the conditions and price of access to the first carrier’s transmission and switching facilities3 It is assumed that the aim of this policy is to achieve an efficient outcome. The ‘need’ for a second (or third or fourth) carrier is not obvious to some observers. In the circumstances where the incumbent prices efficiently and produces in a technically efficient manner, it is easy to imagine that no entry would occur unless interconnection were allowed on very favourable (‘sub-economic’) terms. Such entry would not be socially desirable. Alternatively, in these circumstances any pricing structure which correctly mirrored the shadow price of interconnection would be prohibitive. On the other hand, dissatisfaction with the performance of existing monopoly operations and frustration with the results of traditional regulations have led to calls for competition. Indeed, in many countries network competition has flourished - some would argue as a consequence of generous pricing of interconnection, but more likely as a consequence of existing pricing and cost structures being inefficient and economies of scope being either negligible or small relative to the effects of price and cost inefficiencies.4 Two underlying principles appear to be common to determination of interconnect policy in different countries. Firstly, the local network (including the CAN) has been regarded as an essential facility which must be open to rivals for competition to be ‘successful’. Secondly, governments have not allowed incumbent carriers to determine the price and conditions of access to the essential facility. Bodies like the Federal Communications Commission (FCC) and Oftel have assumed regulatory roles, presumably to prevent monopoly pricing of interconnection. However, the approaches taken have been varied, in most
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cases without explicit regard to the significant input potentially available from public utility pricing principles.5
The efficient component pricing rule (ECPR) Baumol has proposed the following rule for pricing of services supplied by one company to another: ‘A company in a free market which voluntarily rents facilities to another company will do so only if the rental fee is high enough to offer the renter at least as much profit as it could earn by employing the facility itself.’ This becomes the ECPR when the renter is viewed as offering a component in a production chain. Baumol and Baumol and Willig use the example of a railroad offering a journey from A to C which is produced in two components A-B and B-C. The incremental cost of each leg is $3 but the railroad covers its overheads with a contribution of $4 per journey from a price of $10 per journey. The ECPR would dictate that an operator wishing to offer an alternative service using the existing railroad for the A-B segment of the journey and its own facilities for B-C should be charged $7 ($3 incremental cost plus $4 lost contribution to overheads per rival journey). There are several possible definitions of both incremental cost and overhead cost, so it is useful to begin with those stated by Baumol and Willig. Firstly, incremental cost comprises any variable costs attributable to the carriage of the interconnector’s traffic, plus it ‘includes the required profit on any required incremental investment, that is, the cost of the required capital’.6 Overhead costs are ‘the common fixed costs which do not enter the incremental costs of the individual products’.’ There is some ambiguity with both definitions when viewed in the light of the railroad example where, first, no incremental investment would be required and, second, there is only one product (the A-C service). Other cost definitions and interpretations will be introduced later. Baumol and Willig make strong claims for the ECPR. In particular, they assert that ‘it always assigns the supplier’s task to the firm that can do it most efficiently’.* They argue against a lower price for interconnection on the grounds that it is ‘always an invitation to inter-firm cross-subsidy” and that ‘it can lead to entry that raises social costs’.10 We now attempt to assess these claims in the light of, first, the railroad example, and second, the circumstances of telecommunications.
The railroad example 5The classic paper by A. Hazlewood, ‘Optimum pricing as applied to telephone service’, tieview of Economic Studies, Vol 18, 1958-51, PD 87-78 IreDrinted in Pt. Turvey, ed, .Piblic Econ~mks, Penguin, Harmondsworth, UK, 1988, pp 237-257), is still an excellent account of efficient Drinciples for telecommunications pricing. S.J. Brown and D.S. Siblev. The Theorv of Public Utility Pricing, Cambridge Univeky Press, Cambridge, UK, 1988, provide a more modem account. 6Baumol and Willig, op tit, Ref 2, p 31. ‘ibid, p 31. ‘Ibid, p 35. ‘Ibid, p 35. “Ibid, p 37.
416
To consider this example further we must place a little more structure on the problem. Consider a case (Figure 1) where the incumbent’s incremental cost of each leg, MCAB and MCsc, are each invariant with output, and the incumbent has overheads of F; yielding average total cost: ATC = MCA, + MCBc + F/Q.
(1)
Market demand for the whole journey is D. The efficient price consistent with cost recovery is P* with quantity Q*. We also assume that the entrant has its own overhead costs. That is, we assume that overheads relate to the provision of the service, not to the operation of the stages. This seems to be the only sensible assumption that can be made in these circumstances. In the railroad
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Figure 1. Framework for considering Baumol and Willig’s railroad example of their ECPR rule.
QM
Q*
b Q
example there is only one service (A-C) and there will only be one operator (the incumbent or the potential entrant). If the entrant is successful, the original service provider will only operate the A-B stage of the journey and will have no ‘overheads’ - only costs relating to A-B. Consider first the case where the incumbent is cost efficient in its operations and prices on the basis of cost recovery. In these circumstances, assume that an interconnector with the same cost structure wished to offer the A-C service, using the existing carrier for the A-B segment. Under the ECPR the following interconnection charge would be set: MCAB+ F/Q*
(2)
P* - MCBc
(3)
or
The aspiring entrant could not possibly enter as it would have to charge a price of at least P*, plus its own unit overheads. This is the socially efficient outcome because the first carrier is doing the best possible, and driving it out and replacement with an identical carrier is futile. The ECPR passes this simple efficiency test. Now assume the incumbent is efficient in costs but initially prices at the monopoly level PM, with quantity Q”. With the ECPR, and where the potential entrant would have the same overheads, the aspirant could only begin forcing a more efficient price where the existing carrier’s per-unit profits exceeded its per-unit overheads, ie where
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where i) is the break-even price at the monopoly output. The extent of any possible efficiency gain is limited by this excess. The ECPR in this circumstance may achieve an efficiency gain but it cannot possibly force the efficient solution. It fails our efficiency test: the ECPR is unable to result in the elimination of monopoly profits by an existing operator. Consider now the case where the incumbent does not exploit its monopoly power but is inferior in cost on the B-C leg, having a marginal cost of MC B,-, greater than that of the aspirant, MC’B~ Society would benefit from having the new carrier operate the route (and the whole service). The ECPR would dictate a price for interconnect of P* - MCigc,meaning that the aspirant could only enter if MC”BC +F=/Q+
MCiA,+F'lQ
(5)
Making the assumption that incumbent and entrant have the same average overheads, substituting in for the components of the incumbent’s costs, and rearranging yields the condition for possible entry in terms of the incumbent’s cost disadvantage:
FlQ<(MC&,-MC'&.
(6)
Clearly there are many circumstances where this will not hold in spite of the entrant having a clear cost advantage, and, indeed, circumstances where it could not possibly hold. In this regard, note that Baumol and Willig’s numerical example would preclude the possibility of entry as
MCzB,>FIQ*
I’M. Cave, ‘Inter-connection pricing’, mimeo, Brunel University,June 1991.
418
(7)
ie even if the aspirant could do B-C for nothing, the cost advantage would be less than the necessary overhead contribution of $4. Assume now that the potential entrant has an advantage on overhead costs. Even if the advantage were absolute (that is, the entrant had zero overheads) it could not equal the existing carrier’s costs after effectively paying for its inefficiency. Obviously the ECPR fails in this case, as it is inconceivable that the potential entrant could have zero overheads, much less negative ones. Cave’s modification of the rule to cover these situations - ‘interconnection charges should be paid at incremental cost plus contribution, where both of these are based upon the data of an efficient operator”’ does not appear to be adequate to redeem the ECPR. Not only is it ‘clearly difficult to implement’ (because the market process is necessary to find efficient operators) but it is also merely the lowering of what will still be an unclearable hurdle (in the case of overheads) or at least a very high one (in the case of the incremental cost). So far we have assumed that overhead costs apply to the whole service, A-C. While this seems to be the natural assumption, at no point do Baumol and Willig mention or imply the possibility of an entrant having overhead costs. It would appear reasonable to assume that they believe that overhead costs for the entrant on operating B-C are zero. It follows that, if the entrant’s overheads for B-C are zero, they should also be zero for the incumbent. This in turn implies that ‘overhead costs’ relate only to the A-B route, and are not really overheads at all. Rather, they are costs which are allocatable to the A-B stage. It is beyond any dispute that an entrant should be charged the incremental cost of its use of the A-B route. However, rather than Baumol and Willig’s definition of incremental cost, the appropriate
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concept of incremental would appear to be:
cost of the A-B stage in these circumstances
C(QAB, QBC)- W, QBC). With this definition of incremental should be set equal to: PAB
=
(8) cost, price for the interconnector
[~(QAB, QBC) - C(O, QBC)I/QAB
(9)
In the simple example of the railroad, this would give the same answer ($7) as Baumol and Willig get, but through very different reasoning.
Application in telecommunications
‘%aumol, op tit, Ref 2, p 27. %I determining actual prices for the local network the concept of incremental cost must account for differences in peak and off-peak costs. These and other factors are considered in R.P. Albon, ‘Interconnection pricing: peak and off-peak considerations’, mimeo, Australian National University, January 1994.
There are several differences between Baumol and Willig’s railroad example and the circumstances in telecommunications as set out earlier in this paper. All of these place the ECPR in a different perspective from the railroad example. Perhaps the most important of these differences are the following. First, real-world entrants into long-distance markets do not take over the entire service. Indeed, they often appear to develop existing sub-markets and to establish new niche markets. Even if overheads were definable and were to be charged to the entrant, only those pertaining to the incumbent’s absolute loss of market are applicable to the entrant. Second, the A-B stage in telecommunications is not just a component in a production process, but also a separate service - that is, local service. This service will make its own contribution to any unallocable overheads, and this will also reduce the charge attributable to the interconnecting party. Third, in telecommunications there is a third stage - the customer access network - which has its own charging basis. Given the extreme inelasticity of access demand, the contemporary approach to telecommunications pricing would seek to place the entire burden of any unattributable overheads on an appropriately devised structure of access charges. Fourth, it is difficult to conceive of what significant unattributable overheads in telecommunications there might be. It should be possible to allocate nearly all costs to particular services. This seems to be conceded by Baumol in his paper discussing interconnection issues surrounding British Telecom: ‘a substantial proportion of BT costs (. . . 80 to 85 per cent . . .) seems to be separable and causally attributable to the individual services responsible’. ‘* The efficient overall solution in telecommunications would seem to lie in the incumbent attributing costs to each stage correctly and charging an efficient price based on incremental cost (as defined at the end of the previous section) at each stage. This would result in complete or almost complete cost recovery. To the extent that there are any unattributable costs, these should be charged to access. In the case of the local network, all uses of it should be charged on the same basis, including the incumbent charging entrants (and itself) the incremental cost of its own use of the local network to connect long-distance and international calls. l3 There is one caveat to this conclusion. Rectifying existing inefficiencies in pricing may not be totally at the discretion of the incumbent. Where, for example, an incumbent is prevented by regulation from
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charging efficient prices for local service - as in Japan and the USA, for example - the entrant should be made to pay the true incremental cost, and perhaps bear a share of the cost of the incumbent’s subsidies.
Conclusions The emphasis in this paper has been on the appropriate rule for the interconnection of competing networks in industries such as telecommunications. There has had to be some preliminary discussion of the issue as to why the government would want to allow interconnection at all. Perhaps the strongest reason is that governments have not been very successful in getting monopolistic telecommunications carriers to behave in socially efficient ways. This, when combined with natural monopoly in at least one segment of the production process, provides a potent case for facilitating competition through an interconnection approach. In arguing for the efficient component pricing rule in telecommunications, Baumol has used the example of a railroad producing one output in two stages. A successful entrant would take over the running of the whole service. In this example, overheads have one of two interpretations - either they attach to the provision of the service or they attach to the A-B stage. In the first case the entrant would, in taking over the service, assume the overheads, and the ECPR is inappropriate. In the second case the overheads are, in fact, part of the cost of operating A-B, and should be reflected in its incremental cost. Again the ECPR is inappropriate. Turning then to the conditions in telecommunications, these are obviously very different from those in the railroad example, and the ECPR is not necessarily applicable here even if it were for the railroad. Indeed, it appears to be inapplicable in telecommunications. In particular, telecommunications costs seem to be largely ‘separable and causally attributable’, and to the extent that they are not, any overheads should be retrieved from service access charges. A properly defined incremental cost rule is appropriate. Where the incumbent is constrained to price inefficiently, a different prescription for the interconnection price may emerge.
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