As we will see, the old practice and the new reforms all depart from the theoretical precepts just described, at the cost of substantial inefficiencies. Indeed, it is fair to say that the participants in the current regulatory debate are on the whole suspicious of Ramsey access pricing. In our view, this mistrust is an amalgam of a legitimate concern that Ramsey pricing of access might be miscast within an otherwise incoherent regulatory framework, and of a misapprehension of its implications.
Two specific objections have been leveled at Ramsey prices: informational requirements and violation of the nondiscrimination rules.
1 Informational Requirements
Academic economists and policymakers both often argue that regulators do not have the information to set Ramsey prices. One leg of the argument, namely, the widespread shortage of relevant information, is correct. Regulatory agencies have a much smaller staff and less contact with markets than telecommunications operators.
But taken as a whole, this argument should look unconvincing to any observer of unregulated businesses. The latter indeed engage in sophisticated marketing strategies. They offer discounts to high-elasticity-of-demand customers, adjust their prices to competitive pressure, and carefully coordinate the pricing of substitutes or complements. The structure of unregulated firms' prices (though not the level if the firms have substantial market power) thus reflects Ramsey-Boiteux precepts. This observation suggests that the most promising alley for implementing Ramsey prices in a regulatory context is to decentralize pricing decisions to the operator.
The idea of decentralizing pricing decisions may be foreign to those who favor heavy regulatory intervention. Yet, a key feature of the regulatory revolution of the 1980s was departure from the detailed setting of individual prices and flexibility to operators to adjust their price structure to demand and competitive pressure conditions. While the implications of this revolution for access prices have been overlooked, we still find it surprising that regulators who routinely design price caps dismiss offhand Ramsey pricing as being informationally infeasible!
2 The Rhetoric of "Fair and Nondiscriminatory" Access Prices
We have observed that optimal access prices are usage based and thus discriminatory. Most experts oppose this implication of Ramsey access pricing and argue in favor of "fair and nondiscriminatory" access prices, a phrase that originated in the competition policy treatment of wholesale markets (e.g., the Robinson-Patman Act of 1936 in the United States) and made its way into almost all regulatory statutes governing the incumbents' wholesale transactions.
The ban on wholesale price discrimination applies to second- and third-degree price discrimination. Second-degree price discrimination consists in offering two different units at two different prices, for example, a two-part tariff involves a fixed fee as well as a variable price and thus implies a steep discount after the first unit of consumption. Menus of two-part tariffs, such as AT&T's retail optional calling plans or the 80–90 percent discounts below retail currently offered by the U.S. long-distance carriers in wholesale transactions, also involve second-degree price discrimination. Third-degree price discrimination in contrast refers to the offering of different tariffs to different categories of users or, by stretching the definition of third-degree price discrimination a bit, for different usages (mobile, data, video, etc.). To be sure, exceptions have been made and have allowed operators to practice some price discrimination at the wholesale level. In the United States, local exchange carriers have been given some flexibility to offer wholesale discounts to respond to competitive access providers (CAPs), after it was perceived that uniform access pricing created some inefficient bypass entry. In the former U.K. regime set up in the early 1990s, BT's long-distance competitor, Mercury, paid higher charges when using BT's local network for international call origination than for domestic call origination (or termination) even though the access service is identical. An instance of third-degree price discrimination in many countries is the differential in access charges for fixed-link and mobile communications.
The ban on third-degree wholesale price discrimination applies both to discrimination between two nonaffiliated carriers in the adjacent, competitive segment, and, if the bottleneck owner is vertically integrated, between a nonaffiliated carrier and the bottleneck owner's division or subsidiary in the competitive segment. The interpretation of the latter nondiscrimination requirement is subject to debate. After all, the pricing of internal transactions is principally an accounting matter, which may have little connection with economic reality. Some experts have understood this form of nondiscrimination as saying that the access price charged to nonaffiliated buyers should be equal to marginal cost (that is, be cost based), since efficient transfer prices for transactions between two divisions of the same firm are equal to their marginal cost. Other experts have given it an "ECPR interpretation" by arguing that access prices that do not exceed the unit profit on the competitive segment (that is, the vertically integrated firm's opportunity cost) allow a competitive subsidiary or a division of the bottleneck owner to break even when it is subject to accounting separation.
The origins of this deep-rooted fear of wholesale price discrimination can be found in competition policy. They are, therefore, worth a short digression into the economics of foreclosure. Let us start with the paradigm of an inventor who holds a patent on an innovation and subcontracts the exploitation of the innovation to some licensees (one can alternatively think of a franchisor subcontracting to franchisees). The licensing contract is similar to an interconnection agreement: The licensees obtain access to the bottleneck (the innovation) at some access price (fixed fee or royalties). How can the inventor make money on her innovation (which most of us would agree is a desirable outcome if society is to provide incentives for innovation)?
Let us start with the wrong way for the licensor to proceed. Suppose that she contacts prospective licensees separately and offers them independent contracts. It is clear that she cannot collect any money in this way, for the following reason: Suppose that she is expected to sign up n licensees. Once she has entered into n licensing contracts, nothing prevents her from contracting an (n + 1)st licensee, thus creating more competition for the existing ones. Anticipating this incentive to "flood the market," existing licensees would not be willing to pay much. Because the total licensing profit is bounded above by the downstream industry profit, stiff downstream competition hurts the licensor. In other words, downstream product market competition destroys the profit that could a priori be gleaned from the upstream monopoly position. (Similarly, McDonald's would be unable to collect any money from franchisees if it could install new franchisees at the doorsteps of existing ones.)
To avoid this disastrous outcome, the licensor has at least three alternatives. First, she can sign an exclusionary contract with, say, one licensor, that stipulates that she will not be able to enter into further licensing agreements. That is, she can create a downstream monopoly contractually and demand the corresponding monopoly profit. Second, she can vertically integrate and undertake the exploitation of the patent herself; she will then have no incentive to engage in excessive licensing because such licensing amounts to expropriating herself. Third, she may ask for (or it may be imposed!) a legal ban on third-degree price discrimination (but not on second-degree price discrimination). In this legal environment, she can offer a fixed-fee/no-royalty licensing contract to all prospective licensees, with the fixed fee equal to the downstream monopoly profit. It is clear that only one potential licensee will enter a licensing agreement, for duopolists in the downstream market would be unable to recoup the high fixed licensing fee.
The economics of wholesale transactions in general are similar to those of licensing and franchising. An upstream bottleneck must find a way to "discipline" the downstream market if she wants to exploit her upstream monopoly power. Whether it is socially optimal to let an upstream bottleneck exploit this monopoly power is another matter. There seems to be intellectual consensus that the owner of an upstream bottleneck should be allowed to exploit some of this monopoly power in order to recoup the fixed investment: An inventor who would be prevented by competition policy from making money on licensing agreements and from integrating downward into development and production would not undertake R&D in the first place. Similarly, incumbent telecommunications operators would not build local loops if they expected not to be able to enjoy some markups when reselling or exploiting the local loops themselves. How much monopoly power should be enjoyed by owners of bottlenecks is a matter of intense debate in competition policy, and antitrust practice (probably rightly) differs substantially across applications. For example, a number of foreclosure practices are well tolerated in the context of licensing and frowned upon in other contexts.
What do those antitrust considerations have to do with the regulated environment of the telecommunications industry? Probably little as such, as they do not take into account the specificities of regulated industries. But there is no denying that such considerations resurface under some regulatory paradigms, and that new issues arise as well. We illustrate these two points in sequence. Let us return to the licensor's third way of reestablishing her market power. We saw that contracts with sharp discounts can enable the licensor to create a downstream monopoly while giving the appearance of nondiscrimination. Transpose this insight to the pricing of the local loop by incumbent local exchange carriers, and recall that ILECs have been allowed to offer substantial discounts to counter inefficient bypass by CAPs. This opportunity to practice nonlinear wholesale pricing raises the concern that an ILEC enters an agreement with a long-distance carrier, AT&T, say, specifying a very high fixed fee and a very low wholesale price. Such a "sweet deal" (a slight misnomer, since the deal would be available to anyone else as well) would not enable rival long-distance companies to compete effectively with AT&T, as they would not have access to the low wholesale price without paying a fixed fee so high that they would be unable to recover it in a competitive long-distance market!
Next, we return to the innovator's second way of restoring her monopoly power. We saw that she can integrate vertically, deny access to nonaffiliated potential licensees, and let her downstream affiliate charge monopoly prices on the applications of her patent. The equivalent situation in telecommunications is provided by a local loop owner serving an adjacent segment, say, long distance. The local loop company has little incentive to create its own competition and is therefore likely to foreclose its rivals on the competitive segment unless the latter are much more cost-efficient or else produce a sufficiently differentiated service.
Suppose now that the vertically integrated innovator is forced to distribute free or cheap licenses to independent licensees. The innovator then has a strong incentive not to cooperate with the licensees in order not to dissipate the downstream profit; for example, she will refuse to supply the missing specifications that makes the invention work or to provide expertise at the development stage. The same holds in telecommunications. As we will later argue, a bottleneck owner who is forced to sell access below or around marginal cost and is otherwise an unregulated competitor in the adjacent segment has an incentive to use nonprice methods to deny access to rivals.
To sum up, one cannot directly apply foreclosure theory as developed for competition policy to regulated environments. Regulatory rules can change the private and social costs and benefits of foreclosure, and further analysis is required before all-encompassing statements such as those related to "fair and nondiscriminatory access" can be made.
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