LRIC. Mats Bergman. LRIC, Nov 6, 2009 Mats Bergman 1 LRIC

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1 LRIC Mats Bergman LRIC, Nov 6, 2009 Mats Bergman 1 LRIC LRIC = Long Run Incremental Cost Long-run means that investment are included in the calculation of (all factors treated as variable) Based on forward-looking, rather than backward-looking ki This gives better incentives for cost efficiency LRIC, Nov 6, 2009 Mats Bergman 2 1

2 Allocation of common an example Stand-alone alone cost for X: C(X)=700+20X Stand-alone cost for Y: C(Y)=600+20Y Co-production cost: C(X,Y)= X+20Y Synergies = 250 Incremental cost for X = X Incremental cost for Y = Y LRIC, Nov 6, 2009 Mats Bergman 3 Assume X=68.5 and Y=72.8 (see p 444) P X, IC =AIC X = 26.5 P Y, IC =AIC Y =24.8 Price below incremental cost Deficit = Assume FDC method, 75 % of common to X P X,FDC =31.5 P Y,FDC =23.6 Deficit =0 Price above stand-alone cost P X,SA =30.2 P Y,SA =28.2 Surplus = LRIC, Nov 6, 2009 Mats Bergman 4 2

3 IC X + IC Y + synergies = C X+Y = = SAC X +SAC Y - synergies = synergies = IC X = IC Y + = SAC X + = SAC Y LRIC, Nov 6, 2009 Mats Bergman 5 Incremental Source: PTS, 2002 LRIC, Nov 6, 2009 Mats Bergman 6 3

4 Incremental For a small increase in volume For a new service For a new group of services Hierarchies of incremental Larger increments reduce common LRIC, Nov 6, 2009 Mats Bergman 7 Fully distributed cost (FDC) Common o can be allocated in proportion o to Number of units Direct Etc An efficient allocation of requires Ramsey pricing R-prices can imply prices above stand-alone cost or below incremental cost (Under certain conditions (incl. subadditivity), Ramsey prices are subsidy free) LRIC, Nov 6, 2009 Mats Bergman 8 4

5 Subsidy-free prices All prices at or above the corresponding average incremental cost and at or below their corresponding average stand-alone cost Apparently reasonable FDC can imply a subsidy For unsustainable natural monopolies, subsidy-free prices do not exist LRIC, Nov 6, 2009 Mats Bergman 9 LRIC in Swedish telecom Succeeded previous FDC model Phased in nd generation of LRIC introduced for mobile summer 2008, will be introduced for fixed Jan 2011 Model input updated annually LRIC, Nov 6, 2009 Mats Bergman 10 5

6 LRIC for fixed telephony 2 main increments: Core increment Costs driven by traffic volumes; the central part of the network Allocated to interconnection (origination + termination) + own long-distance + other services Access increment Costs driven by number of customers; the peripheral parts of the network ( the last mile, copper and fiber access) Allocated to access service LRIC, Nov 6, 2009 Mats Bergman 11 Activity based costing (ABC) LRIC, Nov 6, 2009 Mats Bergman 12 6

7 use Principle for cost allocation required capacity Service 1, Service 2, Service 3, 100 units 100 units 100 units time Total capacity cost = 300 Capacity per unit: 300/5/100 =0.6 for service 1, 2x300/5/100 = 1.2 for services Mats 2 Bergman and 3 13 Increments calculated for a group of services Fixed incremental to a particular service allocated to that service Costs common to a group of services allocated to those services This reduces common Overall common allocated as a proportional markup The LRIC model is really an FDC model! LRIC, Nov 6, 2009 Mats Bergman 14 7

8 Markup for common Servicespecific variable Servicespecific fixed C Slope = LRIC cost incl markup for common Slope = servicespecific average incremental cost Expected volume Slope = marginal cost LRIC, Nov 6, 2009 Mats Bergman 15 X LRIC for mobile telephony In principle 3 main increments Costs driven by area coverage Initially, when takeup is small+in rural areas Assumed small; included in traffic increment Costs driven by traffic volumes Base stations spaced more densely than needed for area coverage Core network Costs driven by number of customers Billing etc LRIC, Nov 6, 2009 Mats Bergman 16 8

9 Markup for common C Slope = LRIC cost incl markup for common Trafficspecific cost Area coverage Slope = marginal cost Expected volume Slope = servicespecific average incremental e cost LRIC, Nov 6, 2009 Mats Bergman 17 X Markup for common C Slope = LRIC (FDC) cost incl markup for common Trafficspecific cost Area coverage Slope = average incremental cost, true LRIC for call termination Expected Expected LRIC, Nov 6, 2009 termination 18 volume volume X 9

10 The LRIC model a reasonable way to implement an FDC pricing Main differences (?) to previous FDC model: To a relatively large extent a price-cap p model A hybrid model, top-down and bottom-up A well-developed methodology for allocating LRIC, Nov 6, 2009 Mats Bergman 19 New model a true LRIC for call termination Will give dramatically lower termination charges See Commission Recommendation on fixed and mobile termination rates, 7 May 2009 Effective for mobile in Sweden summer 2011? LRIC, Nov 6, 2009 Mats Bergman 20 10

11 Top down and bottom up Bottom up: Based on a theoretical, efficient network Top down: Based on an existing network; requires that inefficiencies are eliminated TeliaSonera s for fixed telephony Hybrid model. The one actually used; a combination of the two above LRIC, Nov 6, 2009 Mats Bergman 21 Total allocated per call minute Adjusted for use of network elements, so as to make, e.g., data traffic comparable to voice traffic Some adjustment for traffic profile; it s peak traffic that dimensions the core/mobile network Traffic volumes need to be prediced Interpretation: A cost-sharing model, with the bottom-up model being a price-cap cap model and the top-down model being a cost sharing model LRIC, Nov 6, 2009 Mats Bergman 22 11

12 Mobile model more price cap Based on least efficient (smallest) operator Will change to a 20 % operator Volume risk carried dby operators in short run; actual volumes measured every year Other cost risks carried longer; model revised every 3-4 years Glide paths For introduction of IP routing; for conversion to LRIC, for convergence of interconnection fees LRIC, Nov 6, 2009 Mats Bergman 23 Rate base and depreciation Based on replacement Top down based on price-adjusted ( tilted ) linear depreciation Capital will be of varying vintages, hence linear depreciation works ok Bottom up based on price-adjusted ( tilted ) annuities Based on a theoretical new network, i.e., all assets assumed to be new. Hence linear depreciation will exaggerate need for depreciation LRIC, Nov 6, 2009 Mats Bergman 24 12

13 Fixed and mobile interconnection charges (öre and cents x 10) US, fixed, cents x 10 Sweden, fixed Sweden, mobile Sweden, fixed, (weekdays) LRIC, Nov 6, 2009 Mats Bergman 25 Source: ERG Position paper, LRIC, Nov 6, 2009 Mats Bergman 26 13

14 Inbalances in interconection fees Models generate much higher interconnection fees for mobile Partly because of treatment of access network Fixed telephony subsidizes mobile LRIC med särkostnader, i.e., a genuine LRIC model, is being introduced d LRIC for the termination increment, rather than for traffic in mobile networks LRIC, Nov 6, 2009 Mats Bergman 27 Some complications The model allows peak-load pricing The right of access is a real option. Is this included in the risk premium? Hausman argues it is not Rivals share success but not failure; this gives disincentives to investments Some access services regulated with other metods Leased lines: FDC regulation (a difference?) Bitstream access, retail access (GTA): retail minus LRIC, Nov 6, 2009 Mats Bergman 28 14

15 Problems with LRIC I Requires heavy-handed handed regulation Knowledge of cost of equipment Forecast of element s usage Forecast of rate of technological progress On the other hand, Ramsey ypricing and ECPR require even more information LRIC, Nov 6, 2009 Mats Bergman 29 Problems II LRIC if applied only to access prices gives strong incentives to exclude In particular if genuine LRIC Typically, (forward-looking) cost-based regulation of access is combined with free pricing of competitive services (In theory) the monopolist can only make a profit on competitive segments Exclusion is a mean to increase profitability, since p a+c 2 LRIC, Nov 6, 2009 Mats Bergman 30 15

16 LRIC + deregulation of competitive segments gives incentives to exclude While the need to regulate the competitive segment disappears, the above incentive creates a need to regulate non-price aspects of access: refusal to deal, delays, raising rivals, lowering rivals demand LRIC, Nov 6, 2009 Mats Bergman 31 Problems III As applied in practice, LRIC gives incentives for inefficient entry If increments are large If there s a markup for common (i.e., if really an FDC model) If incumbent s retail price structure is not cost based, i.e., if there are USO requirements LRIC, Nov 6, 2009 Mats Bergman 32 16

17 Problems IV Does not address allocative efficiency appropriately; this requires Ramsey pricing In particular if there are common, then a mark-up is needed for LRIC prices Also if there are fixed that are incremental to a particular product, but where different customer groups with different elasticities iti can be identified d But regulated firm given some freedom, e.g., peak-load pricing, within a service LRIC, Nov 6, 2009 Mats Bergman 33 More to read Modell Referens Document,2002, 2007, see ellframtagandet.pdf and se/upload/documents/se/revised pdf Laffont & Tirole, 2000, Competition in Telecommunications Armstrong, 2002, The theory of access pricing and interconnection, in Handbook of Telecommunications Economics Jullien and Rey, 2008, Notes on the Economics of Termination Charges, IDEI Report 6, available at: OECD, 2004, Access Pricing, available at: LRIC, Nov 6, 2009 Mats Bergman 34 17