Discussion Papers

Werner Neu, Gabriele Kulenkampff

Long-Run Incremental Cost and Price Determination in the Telecommunications Sector – under Special Consideration of Technical Change

No. 323 / August 2009

Summary

The concept of Long-Run Incremental Cost (LRIC) is discussed by addressing all the characteristics and implications that appear to be relevant when it is used for the determination of the costs of ser-vices of telecommunications networks and services. A special focus is on the question whether and to what extent it is necessary to change the concept and its application given the great changes in elec-tronic communications taking place in the form of the replacement of narrowband networks by broad-band networks. The particular aspect of broadband networks is that they are based on new media and a substantially different technology and that their future potential appears to be large and promising although still much shrouded by uncertainty.

In order to allow the identification of the need for change as a consequence of the new developments, a substantial part of the paper (section 2) is devoted to the description of the status quo, i.e. the current understanding of the concept and its application, in particular in the context of bottom-up cost models where, however, also aspects are examined and/or derived that until now have received little or no attention in the literature. Examples are the recognition of the fact that costs necessarily depend on assessments made by the persons in charge (which by the way is true of all approaches to the deter-mination of costs), the implementation of economic depreciation, the derivation of the cost of money as part of the cost of capital, as well as the derivation of the costs of operation and maintenance and common cost. Another part (section 3) deals with the description and assessment of alternative inter-pretations and critiques of the concept.

The analyses in the later part of the paper are to be considered its most essential contribution (sections 4 and 5). It is shown that, since the risk inherent in the new developments is not entirely accounted for through the evaluation by the capital market but presents specific challenges for management, the application of the LRIC standard requires differentiated assessments of their future chances for suc-cess. It follows that the larger the uncertainty, the less optimistic should the prospects be assessed. More pessimistic assessments imply a smaller rate of utilization of facilities that are currently being installed and therefore justify higher costs. This should hold in particular also when the LRIC standard is used by regulatory authorities to determine prices of regulated new services. Furthermore it is shown that for cost determination it is necessary that the new broadband services be defined within classes of services. This also implies the fixing of quality standards (e.g. requirements with regard to delay, jitter or packet loss). Without such a fixing of quality it would be difficult to unambiguously determine costs.

The regulatory challenges of price regulation during the phase of technological transition, which do not involve long-run considerations, are also addressed. In section 5 the relationship between costs ac-cording to the LRIC standard and social opportunity costs is used to justify the establishing of prices for old services which are now either also being produced on the basis of new technology or are threat-ened to be displaced by new products on the basis of the new technology. These prices should corre-spond to those that were originally determined on the basis of the LRIC for the old technology. Pro-ceeding this way assures that users will be able to obtain products that correspond to their current business needs at prices that they previously accepted, and at the same time safeguards that the pro-viders get paid at a level that either is above the level of costs that – in the long run – is expected for these products on the basis of the new technology, or corresponds to the current market value of these products.

(Full version only available in German language)

Discussion Paper is available for download.

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