Class 4 Network Industries, Spring, 2014 Price Caps 11/24/2018 Class 4 Network Industries, Spring, 2014 Price Caps Randal C. Picker James Parker Hall Distinguished Service Professor of Law The Law School The University of Chicago 773.702.0864/r-picker@uchicago.edu Copyright © 2000-14 Randal C. Picker. All Rights Reserved.

November 24, 2018 NY Times, Nov. 21, 1974

November 24, 2018 NY Times, Nov. 21, 1974

November 24, 2018 NY Times, Nov. 21, 1974

November 24, 2018 NY Times, Nov. 21, 1974

November 24, 2018 NY Times, Aug 4, 1983

November 24, 2018 NY Times, Aug 4, 1983

November 24, 2018 NY Times, Aug 4, 1983

Local Exchange Carrier1 (LEC1) A long distance call is carried by IXC between customers in LEC1 and LEC2. How much does the IXC have to pay to LEC1 and LEC2 for their services in completing the call? Local Exchange Carrier1 (LEC1) Interexchange Carrier (IXC) Local Exchange Carrier2 (LEC2) November 24, 2018

Natural Monopoly: Two Key Pricing Issues 11/24/2018 Natural Monopoly: Two Key Pricing Issues Above MC Pricing Loses Welfare Pricing above marginal costs entails a loss of welfare. There are consumers who would be happy to pay more than what it costs to generate the next unit who will be denied access to the good. November 24, 2018

Natural Monopoly: Two Key Pricing Issues 11/24/2018 Natural Monopoly: Two Key Pricing Issues MC Pricing Causes Insolvency At the same time, if price is set at marginal cost, the firm loses money. It recovers only the marginal costs of production and does not recover its fixed costs. November 24, 2018

Ramsey Pricing: Max Welfare Subject to Solvency 11/24/2018 Ramsey Pricing: Max Welfare Subject to Solvency Goal Set prices so as to maximize consumer welfare while ensuring that the firm is just solvent. Question How do we price in the best way while recovering the fixed costs? November 24, 2018

Ramsey Pricing: Max Welfare Subject to Solvency 11/24/2018 Ramsey Pricing: Max Welfare Subject to Solvency Intuition Lose less social welfare by trying to recover the fixed costs from the relatively inelastic market November 24, 2018

Key Ideas Goal Price Discrimination 11/24/2018 Key Ideas Goal Maximize consumer surplus subject to a solvency condition Price Discrimination Markets are assumed to be separable (meaning that we can set different prices for different consumers) (Seniors don’t buy and resell to youngsters) November 24, 2018

Graphics Demand Curves P A1 A2 C2 Demand C1 Demand Q November 24, 2018 11/24/2018 Graphics Demand Curves P A1 A2 C2 Demand C1 Demand Q November 24, 2018

Using the Demand Curves 11/24/2018 Using the Demand Curves Shape of Demand Pay attention to how “steep” or “flat” the demand curve is Steep = Insensitive Steep means that the consumer is not sensitive to price changes, flat the opposite Basic idea is to stick price-insensitive with fixed costs November 24, 2018

The Inverse Elasticity Rule 11/24/2018 The Inverse Elasticity Rule General Ramsey Formula with Linear Demands Where i is the elasticity of demand for market I November 24, 2018

The Inverse Elasticity Rule 11/24/2018 The Inverse Elasticity Rule Elasticity of demand for a market is the percentage change in quantity divided by the percentage change in price for a given price change Gap between P and MC is where we recover fixed costs November 24, 2018

Intuitions Gross Multiplication Try Again Small x big = big x small 11/24/2018 Intuitions Gross Multiplication Small x big = big x small Big x small = small x big Try Again Put differently, the greater the relative elasticity of demand in market 1, the smaller the difference should be between prices and marginal cost for that market That gap represents the extent to which the firm is trying to recover fixed costs from that market November 24, 2018

Issues and Limitations 11/24/2018 Issues and Limitations Single-Part Pricing Information Limitations Need lots of info to implement Technical Limitation This version assumes that there is no cross-elasticity of demand between the two markets. (Price in one market does not effect demand in the second.) November 24, 2018

Issues and Limitations 11/24/2018 Issues and Limitations Fairness Limitations Individuals with reduced choices may have relatively inelastic demands, and they will get stuck with a disproportionate share of the fixed costs. November 24, 2018

AT&T Price Cap Order (FCC, 1989) November 24, 2018 AT&T Price Cap Order (FCC, 1989)

AT&T Price Cap Order (FCC, 1989) November 24, 2018 AT&T Price Cap Order (FCC, 1989)

AT&T Price Cap Order (FCC, 1989) November 24, 2018 AT&T Price Cap Order (FCC, 1989)

Price Caps v. Rate of Return Regulation 11/24/2018 Price Caps v. Rate of Return Regulation Perverse or Missing Incentives under Rate of Return Regulation Utilities just pass through costs (subject to prudence); no incentive to reduce costs or innovate If utility has regulated and unregulated components, will dump costs from unreg to reg November 24, 2018

Price Caps v. Rate of Return Regulation 11/24/2018 Price Caps v. Rate of Return Regulation Price Caps Set maximum price and let utility keep profits under that FCC Process Commences study in 1987 Eventually sets based on rates of 1 July 1990 And then it goes on and on and on November 24, 2018

Price Caps with Only One Product 11/24/2018 Price Caps with Only One Product Hypo M, a monopolist, sells one product Regulator controls monopoly power by setting a maximum price for the product We should expect M to go to the cap Not very interesting November 24, 2018

Price Caps with Two Products 11/24/2018 Price Caps with Two Products Hypo M, a monopolist, sells two products Regulator sets a maximum price for each product Same situation: expect M to set max price Not interesting still November 24, 2018

Price Caps with Two Products and Trade-Offs 11/24/2018 Price Caps with Two Products and Trade-Offs Hypo M, a monopolist, sells two products Regulator sets a maximum price schedule for the products, allowing trade-offs between the products What price does M charge for the products? Now we have something more interesting November 24, 2018

Price-Caps with Two Goods: National Rural Example 11/24/2018 Price-Caps with Two Goods: National Rural Example First Period Two Goods: A and B A sells for $1, B for $2 Faced with those prices, Consumer buys 100 units of A and 100 units of B spending $300 November 24, 2018

Price-Caps with Two Goods: National Rural Example 11/24/2018 Price-Caps with Two Goods: National Rural Example Second Period Pricing Decision Utility can set any prices for A and B such that at those prices, Consumer could still buy the same (100 A, 100 B) bundle for $300 November 24, 2018

Implementing Price Caps 11/24/2018 Implementing Price Caps This means that prices for A and B are given by the formula: 100 * PA + 100 * PB = 300. So set PA = 0.75 and PB = 2.25 Or set PA = 0.50 and PB = 2.50 November 24, 2018

Implementing Price Caps 11/24/2018 Implementing Price Caps Consumer Revealed Preference and Price Caps Our abstract consumer is necessarily no worse off, and perhaps better off when the utility resets its prices. November 24, 2018

Consumer Welfare under Price Caps 11/24/2018 Consumer Welfare under Price Caps First Period Consumer faces PA (1) and PB (2) and ultimately chooses QA (100) and QB (100) for a total expenditure E (300) This gives us a “budget line equation” of: PA * QA + PB * QB = E November 24, 2018

First Period QB 150 Utility Isoquant 100 Budget Line 300 QA Budget Line: Amount consumer can purchase of each product for a given budget 11/24/2018 Utility Isoquant: Along a given curve, consumer is indifferent between different bundles of goods A and B. First Period QA QB Utility Isoquant 150 300 Budget Line 100 November 24, 2018

Second Period: Swivel the Budget Line : Set PA = 2, PB = 1 11/24/2018 Second Period: Swivel the Budget Line : Set PA = 2, PB = 1 What can we say about the utility of our representative consumer? 100 Utility Isoquant QA QB 150 300 Budget Line Gained Lost November 24, 2018

11/24/2018 Consumer Welfare Key Idea: Consumer at least well off and might be better off Preferred original selection to lost area, so lost area irrelevant (inferior) to preserved choice from first period Might prefer new area to original choice, so not worse off and maybe better off November 24, 2018

Consumer Welfare Limitations Different Consumers Other price changes 11/24/2018 Consumer Welfare Limitations Different Consumers Other price changes November 24, 2018

Statutes Section 201(b) of the Communications Act (47 U.S.C. § 201(b)) 11/24/2018 Statutes Section 201(b) of the Communications Act (47 U.S.C. § 201(b)) Charges for interstate or foreign communications “shall be just and reasonable” November 24, 2018

Statutes Section 202(a) of the Act (47 U.S.C. § 202(a)) 11/24/2018 Statutes Section 202(a) of the Act (47 U.S.C. § 202(a)) Bars carriers from engaging in “unreasonable discrimination,” giving “any undue or unreasonable preference,” or subjecting persons or localities “to any undue or unreasonable prejudice or disadvantage.” November 24, 2018

Price Caps: General Structure 11/24/2018 Price Caps: General Structure General Structure PT+1 = PT * (1+g) where G is Inflation – X-Factor X-Factor up for grabs Originally, X-factor was 3.3%, reflecting historical productivity gains of 2.8% plus a consumer dividend of 0.5% November 24, 2018

National Rural Telecom: Baskets and Bands 11/24/2018 National Rural Telecom: Baskets and Bands Baskets How many budget lines will we have? One: permits trade off across prices of all services provided by the utility Two or more: limits flexibility What is this about and what should drive this? Allocation of fixed cost question again November 24, 2018

National Rural Telecom: Baskets and Bands 11/24/2018 National Rural Telecom: Baskets and Bands Bands Streamlined review procedures for small changes in prices Design to minimize wide swings in prices that might be allowed within the basket November 24, 2018

AT&T Price Cap Order (FCC, 1989) November 24, 2018 AT&T Price Cap Order (FCC, 1989)

AT&T Price Cap Order (FCC, 1989) November 24, 2018 AT&T Price Cap Order (FCC, 1989)

Sharing and Price Caps Limits on Profitability Under a Price Cap Rule 11/24/2018 Sharing and Price Caps Limits on Profitability Under a Price Cap Rule For specified rate of return: Keep everything if within 1% of that return Give back ½ of profits above a return between 1% and 5% Give back all of incremental profit if exceed 5% What incentives result? November 24, 2018

Regulatory Menus: Choosing the X Factor 11/24/2018 Regulatory Menus: Choosing the X Factor Rule gave regulated firm choice about X factor If choose 3.3%, 50% sharing kicked in at returns above 12.25% and 100% at 16.25%. If choose 4.3%, 50% sharing started at 13.25% and 100% at 17.25%. How should a firm choose? What will the regulators learn? November 24, 2018

Regulatory Menus Theoretical Framework of Asymmetric Information 11/24/2018 Regulatory Menus Theoretical Framework of Asymmetric Information The regulated know things that the regulator would like to know but cannot Regulator makes “screening” offer, so that firms will effectively reveal information through their choices November 24, 2018

Regulatory Menus Think of X-Factor Choice Menu in that Framework 11/24/2018 Regulatory Menus Think of X-Factor Choice Menu in that Framework How does the fact that the choice communicates information alter the choice itself? November 24, 2018

11/24/2018 Bell Atlantic (D.C. Cir. 1996) Actual Practice under the 1990 Price Cap Regime Sharing ubiquitous 1994 Revisions Re-evaluate original data and original methodology Toss 1984 data and keep original methods on interim basis November 24, 2018

Bell Atlantic (D.C. Cir. 1996) D.C. Circuit blesses this 11/24/2018 Bell Atlantic (D.C. Cir. 1996) Moves from 3.3% min to 4.0% “Reinitializes” caps to put them going forward at the 4.0% rate Sets 4.7% and 5.3% as sharing cutoffs D.C. Circuit blesses this November 24, 2018

Bell Atlantic (D.C. Cir. 1996) Reinitialization Idea 11/24/2018 Bell Atlantic (D.C. Cir. 1996) Reinitialization Idea Suppose initial cap is 100 at time 0 and X factor is 3 Then at time 1, cap is 97, time 2 cap is 94, time 3 cap is 91 (ignoring compounding as the opinion does) November 24, 2018

Bell Atlantic (D.C. Cir. 1996) Reinitialization Idea 11/24/2018 Bell Atlantic (D.C. Cir. 1996) Reinitialization Idea With reinitialization, once we learn that the X factor should have been, say, 4, we don’t retroactively reset the cap to apply to the past, but we do set it going forward as if the X factor had been 4 all along November 24, 2018

Bell Atlantic (D.C. Cir. 1996) Reinitialization Idea 11/24/2018 Bell Atlantic (D.C. Cir. 1996) Reinitialization Idea Meaning the time 4 cap isn’t 88, but is instead 100 – (4x4) = 84 November 24, 2018

U.S Tel Ass’n (D.C. Cir. 1999) 1997 Rulemaking Abandons sharing 11/24/2018 U.S Tel Ass’n (D.C. Cir. 1999) 1997 Rulemaking Abandons sharing Sets historical X-Factor of 6% and keeps 0.5% consumer productivity dividend “Reinitializes” price cap again, but just for 1996 November 24, 2018

U.S Tel Ass’n (D.C. Cir. 1999) D.C. Circuit Rejects Why 6.0? Why 0.5? 11/24/2018 U.S Tel Ass’n (D.C. Cir. 1999) D.C. Circuit Rejects Why 6.0? Why 0.5? November 24, 2018

11/24/2018 X-Factor Estimates November 24, 2018

X-Factor Year-by-Year Plot 11/24/2018 X-Factor Year-by-Year Plot November 24, 2018

Understanding Incentives with Dynamic Regulation 11/24/2018 Understanding Incentives with Dynamic Regulation Issue Regulators adjust the X-Factor in response to actual events The industry should anticipate this response How will this alter behavior? Does it matter if we tie price cap change to individual firm’s behavior? Average firm’s behavior? November 24, 2018

Understanding Incentives with Dynamic Regulation 11/24/2018 Understanding Incentives with Dynamic Regulation Analysis With ties to individual behavior, firms will likely factor regulatory response into decisions This weakens incentives of price caps to reduce costs November 24, 2018

Understanding Incentives with Dynamic Regulation 11/24/2018 Understanding Incentives with Dynamic Regulation Analysis With ties to average behavior, individual firm can’t control what competitors will do, and average will largely be controlled by others (collective action problem) Individual firm should save as much as it can November 24, 2018

USTA (1999) Too Many Changes? 11/24/2018 USTA (1999) Too Many Changes? “The situations are somewhat similar, but the FCC adequately distinguished them. It rested its 1997 decision to limit reinitialization on the need to ‘limit harm to LEC productivity incentives that could result from the perception that our regulatory policies unnecessarily lack constancy.’” November 24, 2018

11/24/2018 USTA (1999) “It seems clear that a second extensive reinitialization would considerably aggravate such a perception.” “Universal, complete reinitialization would impair the supposed incentive advantages of price caps—which derive from firms’ supposing that their efficiencies will not come back to haunt them.” November 24, 2018

TOPUC (5th Cir. 2001) and FCC Follow Up 11/24/2018 TOPUC (5th Cir. 2001) and FCC Follow Up Setup FCC stays with 6.5%, but just as transitional mechanism no longer tied to productivity 5th Cir: No explanation for 6.5% FCC Response Industry participants agreed and presented no other number November 24, 2018

And More? Verizon v. FCC, 453 F.3d 487 (D.C. Cir. 2006) 11/24/2018 And More? Verizon v. FCC, 453 F.3d 487 (D.C. Cir. 2006) Rate for 1993 and 1994 being litigated in 2006 November 24, 2018