ON COST-BASED PRICING FOR REGULATION

Peter Linhart and Joseph H. Weber
Weber Temin & Co.

Among the provisions of the Telecommunications Act of 1966 are
requirements that incumbent carriers make their services and
facilities available to competitors at prices based on costs.
We focus in this paper on the methodology used to establish the
price for such services and facilities. We first establish
criteria which any pricing methodology should meet. Specifically,
prices:

1) Should not be so high as to deter entry.
2) Should not be so low as to make the incumbent firm non-viable.
3) Should provide an incentive for efficiency (cost-reduction).
4) Should not require outside subsidies,
5) Should not discourage the entrant from building its own
facilities, if this is the economically desirable solution.

As required by the enabling legislation, the FCC has approached
this problem from the point of view of cost-based pricing.
There are two principal types of cost-pricing: First, average-cost
(or fully distributed cost) pricing, based on historical costs.
Second, incremental cost-pricing, based on forward-looking
incremental costs. The latter method is felt to have the desirable
properties possessed by marginal cost pricing in certain theoretical
models.

We discuss the implications of each method, and show how Long Run
Incremental Cost Pricing (LRIC) evolved into Total Service LRIC
(TSLRIC) and finally Total Element LRIC (TELRIC), losing in the
process some of the advantages that were used to justify LRIC in
the first place.

We then calculate the differences in the costs that would result
from the use of each method, based on reasonable assumptions of
technological change, growth rates and depreciation lives, and
demonstrate that neither of the proposed approaches satisfy the
desired criteria. In a simplified numerical example based on the
U.S. telecommunications industry, we are able to estimate the
amount of the subsidy that would be required to keep the incumbent
firms viable under TELRIC; we relate these results to those
obtained using the Hatfield model.


Finally, noting that technological change, particularly in wireless
communications, is rapidly making facilities-based competition a
truly viable alternative, we analyze the incentives that the
various parties have to negotiate agreements for resale and
leasing. We describe in detail how, based on these incentives,
market forces will lead to prices that satisfy the criteria listed
above. We conclude that, with the exception of a ceiling on the
price for interconnection and the usual price floors to prevent
predation, there is no need for regulation to set these prices.
We further argue that if the market is allowed to set the price
rather than the regulator, the current environment of endless
litigation and foot-dragging by dissatisfied parties will be
eliminated, leading to a much more rapid introduction of true
competition into local exchange markets.