Discussion Papers

Marcus Weinkopf, Werner Neu

Regulatory Issues Concerning Relations Between Monopoly and Competitive Services of DBP Telekom
Nr. 71 / September 1991

Summary

The recent reform of the telecommunications sector in the Federal Republic of Germany requires a new regulatory framework governing the supply of monopoly and competitive services by the new entity DBP Telekom. One central issue within the regulatory process will be the regulation of financial transfers between both service areas.

We take up this issue by analyzing possible incentive structures which can lead the firm to setting prices of certain services below costs. Basically, we assume an undistorted incentive for long-run profit maximization in order to exclude any distortions resulting from particular regulatory approaches (like, e.g., rate-of-return regulation). Our model wholly builds on planned prices and revenues. This is to exclude unforeseeable developments which do not influence the firm's planning ex ante.

For our analysis we make a clear distinction between a temporary deficit of a service (relative to its incremental costs), and an overall deficit in the sense that a service's discounted stream of revenues minus incremental costs over the whole planning horizon is negative. Both types of pricing below costs will only occur if certain inter-dependences exist which cause overall profits to rise when one of the services is priced below costs temporarily or continuously.

- An inter-temporal dependence can lead to incentives for penetration pricing or predatory pricing, where the firm temporarily prices one service below incremental costs, followed by a price increase in later periods. If demand in future periods is positively correlated to demand in the former periods, this strategy may lead to higher overall profits than in the case of pricing at or above incremental costs in all periods.

- An inter-service dependence can lead to an incentive for permanent cross-subsidization of a competitive service. In case of demand complementarities between a monopoly service and a competitive service, any incremental unit of the former which can be sold due to a price decrease leads to additional demand for the latter and thus may generate additional contributions which exceed the amount of the cross-subsidy.

Given the dynamic nature of most non-reserved telecommunications markets, the first case does not seem to be of particular importance for the regulation of DBP Telekom. We think, however, that the second case could be of great relevance because of existing complementarities between the monopoly services on the one hand and various competitive services on the other. We test different regulatory approaches to cross-subsidization and conclude that a flexible regulatory approach without strict cost allocation standards or restrictions for pricing of competitive services, combined with price regulation of the monopoly services, fits best to ensure non-discrimination of competing firms as well as the protection of the monopoly service's customers against abusive pricing policies.

An earlier version of this paper was presented to the 5th European Communications Policy Research Conference 1990 in Porquerolles, France.

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