Global Price Cap

The most promising avenue for basing of the rate structure on demand considerations and reducing the scope for the capture is to delegate pricing to the telephone operator through a price cap. Some will counter that the firm itself may have imperfect knowledge of the demand curve. But imperfect knowledge of the demand curve has never prevented unregulated firms from practicing subtle forms of price discrimination, charging low prices for products with elastic demands and high prices for products with low elasticities, adjusting prices to reflect the intensity of competition, and correcting prices upward when selling substitutes and downward when selling complements.
In theory, the Ramsey pricing structure can be obtained by imposing a global price cap on the incumbent, with the following features:
  1. The intermediate good (access) is treated as a final good and is included in the computation of the price cap (this is the definition of a global price cap).
  2. Weights used in the computation of the price cap are exogenously determined and are proportional to the forecasted quantities of the associated goods.
That is, a price cap induces a firm to select the proper Ramsey structure as long as all goods (including, here, access goods) are included in the definition of the cap and the weights are exogenously fixed at the level of output that will be realized.

The intuition for this result is straightforward: An unregulated firm with market power does not maximize social welfare because it does not internalize the increase in consumer net surplus brought about by a price reduction. A $1 decrease in the price of a service increases consumer net surplus by an amount equal to the consumption of that service. Let us now look at profit maximization by a regulated operator subject to a price cap covering all its services. The global price cap forces the firm to internalize the increase in consumer net surplus in proportion to the weights in the cap (the coefficient of proportionality is the shadow cost of the price cap constraint). Therefore, if the weights in the global price cap are equal to realized consumption quantities and the level of the cap is chosen appropriately, the operator perfectly internalizes net consumer surplus when maximizing profit.

This result holds for any demand structure and, in particular, allows for the possibility of substitutability between access goods and final goods. That is, a global price cap in principle allows a proper usage-based pricing structure apparently without a need for the regulator to know the demand functions. As we will see, however, the exogeneity of weights qualifies this encouraging result, as weights based on realizations of output create some difficulties.

The global price cap assumption is at odds with standard practice. Actually, the very debate about access pricing rules reflects the general view that intermediate and final goods should be treated asymmetrically. A global price cap implicitly denies the difference between access services and other services.

Remark 1: Price Cap and Profit Sharing It is important to point out that we give the phrase "price cap" a more general meaning than contemporary regulatory usage. A price cap is logically consistent with profit-sharing rules, although its usage has been restricted to situations in which the regulated firm is (theoretically) residual claimant of profit. That is, once a price cap has been set, any profit-sharing mechanism can be superimposed without affecting the implementation of the structure of Ramsey prices.

Remark 2: Cross-Subsidies A global price cap makes the operator residual claimant of profit until the next regulatory review. Any crosssubsidy can only reduce profit during that period. But we should also ask whether the intertemporal profit sharing associated with the ratchet effect can recreate incentives for cross-subsidies. To the extent that the revision of the global price cap at the regulatory review is based on the operator's overall profitability (not on individual segments), the operator cannot gain by reducing its current profit through cross-subsidies (otherwise, it could also gain by "burning money").