Common Costs and Cross-Subsidies: Why Do Common Costs Appear So Large in Regulated Industries? Mark L. Burton David L. Kaserman John W. Mayo University of Tennessee Auburn University Georgetown University

Regulation and Common Costs: Telecommunications Rate of Return Regulation Price Caps Telecommunications Act –to establish a pro-competitive, de-regulatory national policy framework Protection –From Protection to Competition-Enabling

Entry Paths Facilities-Based Pure Resale Unbundled Network Elements (UNEs) –„based on costs“

Common Problems with Common Costs The Lack of a Consistent Definition –„revenues to be allocated to the other guy“ The Time Perspective –Long Run v. Short Run Services-Based Identification of Common Costs –UNEs v. Services Failure to Identify Stage-Specific Common Costs Residual Identification of Common Costs

C(Q 1, Q 2 ) = CC + F 1 + F 2 + f (Q 1 ) + g (Q 2 ),(1) where, > 0 if Q 1 > 0, Q 2 ≥ 0 Q 1 ≥ 0, Q 2 > 0 CC = 0 if Q 1, Q 2 = 0, (2) and, > 0 if Q i = 0, F i = 0 otherwise. The Economics of Common Costs and Cross-Subsidy

AIC1 = [C(Q1, Q2) – C(0, Q2)] / Q1 = {[CC + F1 + F2 + f(Q1) + g (Q2)] – [CC + F2 + g(Q2)]} / Q1 = [F1 + f(Q1)] / Q1. SAC1 = C(Q1, 0) / Q1 = [CC + F1 + f(Q1)] / Q1. AIC1 < p1 < SAC1, or {[F1 + f(Q1)]/Q1} < p1 < [CC + F1 + f(Q1)]/Q1. The Economics of Common Costs and Cross Subsidy

Proposition 1 If common costs are estimated correctly, cross-subsidies cannot be created by any allocation these costs.

Proposition 2 Where costs that are, in fact, marginal to a given product have been mislabeled as “common”, subsequent misallocation of such costs can produce cross-subsidies.

Conclusions Historically, the (mis) treatment of Common Costs has caused severe harm to goal of allocative efficiency The goal to promote competition in telecomunications raises the proscpect that additional anticompetitive damage will ensue Focussing on mis-allocation problems is misplaced (misallocation cannot cause cross-subsidies) Mis-estimation should be focus (If Common Costs are inflated cross-subsidies can occur.)