The traditional approach to computing interconnection charges consists in applying the methodology of cost-of-service regulation to the operator's wholesale offerings. There are a variety of possible cost allocations.
A popular cost-of-service methodology is that of additive or usage-proportional markups. Suppose that several services utilize a common element. After the allocation of costs that are attributable to a particular service to the corresponding services, there remains a residual corresponding to the "fixed cost" or "common cost." This unallocated residual is then spread across services, and the additive markup on each price is the same for each service. In other words, a usage-proportional markup is tantamount to a fixed (price-independent) excise tax, whose magnitude is computed so as to cover the unallocated cost.
It is interesting to note that usage-proportional markups satisfy the ECPR. ECPR requires the access price to be equal to the operator's opportunity cost on the competitive segment. The operator's price on the competitive segment is equal to total marginal cost, that is, the marginal cost of access plus the marginal cost of the segment itself, plus the markup. The access charge, which is equal to the marginal cost of access plus the markup, is thus equal to the difference between the price and the marginal cost on the competitive segment, that is, the opportunity cost.
Another popular approach to allocating the fixed cost is that of uniform or price-proportional markups. The markup over the marginal cost of a service is proportional to this marginal cost. The uniform markup is thus akin to a proportional (VAT type) tax. Unlike additive markups, uniform markups do not satisfy ECPR. Because the total marginal cost of the competitive segment exceeds the marginal cost of the access facilities used by this segment, the price of the competitive segment is inflated more than that of the access segment, and so the access charge is set below the operator's opportunity cost. The burden of cost recovery then falls disproportionately on the competitive segments.
The benefit of fully distributed cost pricing is that it commits the regulator to allow the operator to recoup its investments and to break even. Thus, to a large extent, it solves the problem of regulatory takings. In particular, an operator who incurs a large fixed cost to install fiber optics in the local loop or to endow switches with new functions need not be concerned that this investment will later be expropriated by the regulator's setting low access charges, for example.
Despite this advantage, in the context of retail pricing, fully distributed cost pricing has been as frequently decried by economists as it has been used in practice. It has well-known flaws. First, it is determined through a cumbersome process. For example, a rebalancing of access charges must be cost justified, a requirement which is likely to imply a delay of several months in the rebalancing. Second, fully distributed cost pricing is cost based and therefore does not encourage cost minimization. Third, it yields an improper price structure and is a vastly suboptimal way of financing the access deficit. Because it is cost-based, it "subsidizes" inelastic-demand segments to the detriment of elastic-demand ones. In the presence of competition, fully distributed cost pricing tends to create an inefficient amount of entry. For example, under uniform markups, an inefficient entrant producing the same service as the operator in the competitive segment finds it profitable to enter as long as its cost handicap relative to the operator is smaller than the markup on the operator's marginal cost on the competitive segment. Furthermore, under all fully distributed cost methods, the markup on access invites inefficient bypass.
To alleviate the cost of the first and third drawbacks (delays in price revisions, inefficient entry in the competitive and bottleneck segments), the prices set by fully distributed cost methods have sometimes been interpreted as ceilings or caps, providing, in particular, flexibility to respond to competitive threats such as those by competitive access providers. By letting operators respond to competition, this downward flexibility has perhaps brought actual prices closer to Ramsey levels, but fully distributed cost methods still have only limited appeal.
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