How should regulators set limits on the prices charged for access to ‘bottleneck facilities’
in network industries like telecoms, railtrack, water, electricity and gas? The question is
on the agenda right now as the media-to-telecoms regulator Ofcom tries to force BT to
cut its charges to rivals for access to its broadband internet network.
New research by Dr Ian Dobbs, published in the April Economic Journal, provides some
valuable insights on the ideal approach. In particular, he shows how in emergent markets
where there is much uncertainty about future demand and future technical progress, firms
that control ‘bottleneck facilities’ can respond to price cap regulation by slowing the pace
at which network capacity is ‘rolled out’ – as has happened, for example, with broadband
internet access.
Dr Dobbs notes that firms that control ‘bottleneck facilities’ have typically been required
by regulators to provide open access to these facilities. Of course, access is offered at a
price – and so, given the inherent monopoly power associated with access provision,
regulators generally try to cap the prices that the facility owners are allowed to charge.
Dr Dobbs argues that access pricing should be viewed as an ‘intertemporal’ problem, in
that access prices are for short-run access to long-lived (typically network) capacity.
These capacity investments are largely ‘irreversible’ and are risky in several ways:
· first, because technical progress reduces the cost of providing capacity;
· and second, because over time, the level of demand may not evolve as expected
and/or new service innovations may erode or destroy it.
At present, regulators ignore uncertainty in demand and technical progress when setting
limits to access prices. Dr Dobbs shows that uncertainty can raise price levels even in the
nirvana of a competitive market – and that not taking it into account can significantly
reduce the incentive to invest in new capacity.
In the absence of uncertainty, setting a regulatory price cap that restricts the price to the
competitive level can work quite well – in inducing the network provider to invest in the
right level of capacity, and in providing the correct incentives to those that wish to gain
access.
Under uncertainty by contrast, Dr Dobbs shows that this form of price cap gives an
incentive for the firm to under-invest over time and to install too little capacity, while at the
same time rationing demand.
The basic reason for this is that uncertainty shocks have asymmetric importance. When
demand falls, the firm must reduce prices – in order to maximise returns by making full
use of existing capacity since the opportunity cost of doing so is typically very low. But
when demand expands, the firm’s price is capped by the regulator.
As a result, the firm will ration demand and limit its additions to capacity. It does this to
reduce the risks associated with future downswings in demand: having less installed
capacity means it takes less of a hit on prices if demand does subsequently fall.
The effects can be quantitatively very significant, although naturally, by how much
depends on the extent of uncertainty, the rate of technical progress and so on.
Essentially, the single instrument of the access price cannot deal with the twin demands
of (a) promoting efficient use of existing capacity and (b) inducing an efficient level of
investment in new capacity over time.
Dr Dobbs recommends that regulators should make upward adjustments in access prices
to reflect the impact of uncertainty on irreversible investments. But they should also be
alert to any forms of ‘quantity rationing’.
In practice, firms may find rationing of existing customers politically difficult – but there are
other forms of rationing that are easier to get away with, particularly in emergent markets.
It is much easier to ration potential new customers as can occur through slowing the pace
at which network capacity is ‘rolled out’ – as, for example, with broadband internet access.
ENDS
Notes for Editors: ‘Intertemporal Price Cap Regulation under Uncertainty’ by Ian Dobbs
is published in the April 2004 issue of the Economic Journal.
Dr Dobbs is Reader in Business Economics and Finance at the University of Newcastle
upon Tyne Business School.
For Further Information: contact Ian Dobbs on 0191-222-6830 (email:
i.m.dobbs@ncl.ac.uk; website: http://www.staff.ncl.ac.uk/i.m.dobbs/); or RES Media
Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email:
romesh@compuserve.com).