Price discrimination, separation and access ...

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Price Discrimination, Separation and Access: Protecting Competition or Protecting Competitors? Stephen P. King Australian Journal of Management 1999 24: 21 DOI: 10.1177/031289629902400102 The online version of this article can be found at: http://aum.sagepub.com/content/24/1/21

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Price Discrimination, Separation and Access: Protecting Competition or Protecting Competitors? by

Stephen P. Kingt

Abstract: Reform m utility zndustrzes often znvolves the owner of a key essentzal lacllzty sellzng access to that facrllty to downstream competitors. Examples Include local telephone access and transmiSSIOn or distributIOn system access zn gas and electnczty. The access przce IS ofien set by a separate regulator, but downstream competztors may clazm that the proVider sells access at a lower przce to ItS own down stream subsidiary ThiS paper exammes the basIs for such clazms. We show that a vertically integrated utzlzty will have mcentlves to engage zn przce dlscrzminatzon. However, thiS may not be antlcompetltlve Rather, przce dlscrzmznatzon may lead to lower cllstomer przces Depending all the entry policy that accompallles the zndustry reforms, przce dlscrzmll1atlOl1 may razse or lower soczal wellare

Keywords: ACCESS PRICING, VERTICAL INTEGRATION, INPUT MONOPOLY, PRICE DISCRIMINATION, TELECOMMUNICATIONS

t

Department of Economlc~, UnIversIty of Melbourne, ParkvIlle VIC 3052

I would lIke to thank Joshua G.ms, an anonymou, referee and semmar partIcIpants at the UnIverSIty of AdelaIde, the UnIverSIty of Melbourne, and the AustralIan CompetItIOn and Consumer CommIssIon for theIr useful comments Austra/wn JOllrnal of Management. Vol 24, No 1, June 1999, © The Allstralwn Graduate School of Management

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Copyright © 2001. All Rights Reserved.

AUSTRALIAN JOURNAL OF MANAGEMENT

1.

June

1999

Introduction

ustralian infrastructure mdustnes are undergomg an unprecedented transformatIOn. Government owned enterpnses, includmg airports, tram compames and electncity generators are bemg privatIsed. Competitive barriers are being removed in telecommunicatIOns, electricIty, gas and other utility industnes. New regulatory authorities, such as the Independent Pncing and Regulatory Tribunal in NSW are bemg created to oversee these changes. One force dnving thIS transformatIOn IS the recommendations of the Independent CommIttee of Inqmry into NatIOnal CompetitIOn PolIcy (the Hilmer report). A key recommendation of thIS report was that, as a general rule, public monopohes should be broken up before competition IS introduced into a utihty mdustry.1 Behind this recommendatIOn IS the idea that 'natural monopoly' and potentially competitive parts of a utility should be separated to prevent distorted competition An integrated uhlity would be able to 'stifle or prevent competItion m the potentially competihve sector' 2 This recommendatIOn was accepted by State, Temtory and federal leaders and IS mcorporated mto clause 4 of the CompetitIOn PnnClples Agreement. But does thIS recommendation make economic sense? The Hllmer report noted that a vertically mtegrated utihty that supphes an essential input to its downstream competitors may 'cross subsidIse' ItS competitive operations from ItS monopoly serVIce. Regulatory interventIOn, such as access pricmg rules and 'nng fencmg' the competItive and monopoly parts of the same company WIll be meffective to prevent anti-competitive cross subSIdies. These same arguments were made in favour of the break up of the US telecommunicatIOns company AT&T m the 1980s 3 The argument rests on two assumptions. FITst, that the relevant authonty cannot perfectly regulate an mtegrated utility so that It provides its downstream competitors wIth access to any essential upstream mput at the true marginal cost of productIOn. Secondly, that m the absence of vertical separation and independent operation, an mtegrated firm cannot be forced to make decisions as if It paid the same access pnce as its competItors, when this pnce exceeds marginal cost. 4 These assumptions are reasonable. ConsIder a telecommunications company, hke Telstra, that controls the local telephone network and also competes m the long-dIstance call market. As of 1998, Telstra's long-dIstance competitors, such as Optus CommunicatIOns, must buy local network access from Telstra as an essential input mto a long-dIstance call It IS dIffIcult for a regulator to set the pnce of local network access exactly equal to margmal cost. The regulator will often be uncertam as to the exact value of the margmal access cost. Also, to the degree that the marginal access cost falls below the long-run average cost of operating the local network, forcmg Telstra to set a umform access price equal to margmal cost would prevent the company from covenng ItS costs m the long-term. If the

A

I 2 3

4

See Commonwealth of Australia (1993), p 237 Commonwealth of Austraha (1993). p 219 See Noll and Owen (1989) There IS a large hterature on the difficulties of settmg effluent regulated pnces See, for example. Carlton and Perloff (1994) and Baron (1989) The Htlmer report notes the madequacy of accountmg separatIOn See Commonwealth of Australia (1993), p 220

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Kmg PRICE DISCRIMINATION, SEPARATION & ACCESS

regulator sets an access price above marginal cost, however, it cannot prevent an mtegrated company like Telstra from potentially price discrimmating. Telstra could 'charge itself' the true marginal cost of local call access while settmg the hIgher regulated price for long-distance call competItors. Requiring Telstra to set the regulated access price as an internal transfer price may have little effect. Telstra can sImply run its accounts to satIsfy the regulator whIle makmg corporate deCIsions based on the true margmal cost of local access The assumptions underlying the 'antI-competitive pnce discnmmation' claim are sensible and are adopted m the model presented m this paper Unfortunately, we show that the conclusIOns that have been drawn from these assumptIons, both in the Hilmer report and m the general debate on mfrastructure refonn, are at best ambIguous and may be false. An integrated utIhty may pnce discrimmate in ItS own favour when selling access to a key input for downstream competItion This pnce discrimmatIOn will hurt competitors. But It may not hurt competitIOn. In fact, under reasonable competItIve conditIons, retaming an integrated utihty and allowing that utility to price dlscrimmate may lead to lower pnces and a higher level of social welfare than If the utility was vertIcally separated and pnce discnminatlOn was made illegal. Put Simply, pnce dlscnminatIOn may hurt competitors but benefit consumers.s Our analysis extends the standard 'double marginahsation' effects of vertIcal separation Agam, consider the case of telecommullications. Suppose the regulated (margmal) price for local network access exceeds the true margmal cost of access. If the fIrm which owns the local network IS also operatmg in the (competItIve) long-distance market and It can pnce discrimmate m ItS own provISIon of local network access, then It will tend to be more aggressive in the long-dIstance market than other retailers. The mtegrated firm, as an entity, faces the true margmal cost of any serVIce expansIOn rather than the higher regulated cost. The aggressive behaviour of the mtegrated firm will crowd-out productIOn by other fIrms but will result in an expansIOn m total output and a fall m the pnce to consumers. This crowding out will arise in the model presented below If there remain entry restnctions after deregulation 6 The gam m consumer surplus associated With dlscnmmatory access pncmg may, however, be at least partially offset by a misallocatIOn of production. If technology m the long-distance market is characterised by mcreasmg margmal costs, then the mtegrated fInn will be producmg 'too much' output compared to the other retailers 7 If deregulatIOn allows free entry then any aggressive behaviour by the mtegrated fIrm will lead to perfect crowding out of productIOn of other fIrms Consequently, final product pnces and consumer surplus will be unaffected when comparing dlscrimmatory and non-dlscnminatory access pricmg ThIs does not 5

6

7

That 'competItIon' I, not the same .1, the 'number ot compelltor,' IS well recogm,ed under AustrdlIan Trade PraclIces Law In thl' paper we Judge etfIclency by the ,tandard economIc med,ure ot ,ocml welfdre that mcludes consumer surplus and producer plOflts Note thdt the lower cost tdced by the Integrated fIrm IS not a socldl gaIn by Itself The hIgher pnce Pdld by competItors SImply represents a transfer to the dccess proVIder The true mdrgInal cost ot dccess IS .II ways the ,arne and IS unaffected by mtegratIon or separatIon The sources of welfare change In thIS case .Ire SImIlar to those IdentIfIed by Katz (1987) change~ In total sales ot Intennedlate and fInal goods, dnd changes In productIOn costs UnlIke our paper, Katz focuses on dl,cnmInatory pncIng to prevent vertIcal IntegratIon

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mean that the chOIce of pohcy does not have competItIve and soc1al welfare consequences. There w1ll tend to be less entry and production will be misallocated If there 1S access pnce discnmmation. While productive misallocation will reduce social welfare this will be more than offset by a social gam due to the reduction in entry. The results presented in this paper have important ram1f1cations for mfrastructure reform m Austraha and other countnes While there may be a number of well-founded arguments m favour of vertical separation, 1t 1S incorrect to clmm that pnce discnmination will harm compet1tIon because of 'antIcompetitive cross subs1disation'.8 This suggests that the presumptlOn in favour of vertical separatlOn adopted in the CompetItion Princ1ples Agreement may be misguided. At the same tlme, price d1scrimmatlOn will often hurt competitors of an integrated utihty We would expect new competItors in gas, electnc1ty and telecommulllcations to argue for strict regulatory controls on the incumbent utility. If the utIlity is vertically mtegrated, the new entrants wIll push for e1ther accountmg or actual separation between upstream and downstream operations. But 1f access price d1scnmmatlOn 1S effectively prevented th1s may raise competItors prof1ts by mutmg competition and raising fmal product prices

2.

Related Literature

Most of the econom1C hterature on pnce discrimmation focuses on monopoly pricmg in a final product market. 9 While some literature has cons1dered price d1scrimmation m vertIcal productlOn chams, the focus has been on the relatlOnship between unregulated upstream prof1ts and fmal market competItlOn. lO Integration and pnce discnmmatIon have been cons1dered by Katz (1987) and Perry (1980, 1989). Katz considers how pnce discnminatlOn may be motIvated by competitors' differential abihty to verhcally integrate, wh1le Perry shows how selective mtegratlOn can fac1litate price d1scnminatlOn It is clear that discnminatory access pncing can have an anti-competitive effect. The most ObVlOUS case is where an upstream firm that controls an essential facility and is mtegrated into downstream production e1ther refuses to provide access or sets a h1gh pnce for access which effectively undermines its downstream compet1tors In the absence of integration, however, it is not obvious that the monopoly owner of an upstream essential fac1hty has an incenhve to pnce discnmmate between downstream producers If the access prov1der can set nonhnear access tanffs to se1ze monopoly prof1ts then there 1S no add1tlonal benef1t m hm1hng downstream competItlOn (see Kmg & Maddock 1996) In fact, limiting downstream competltlOn may reduce the prof1t of the local network owner If it makes it more diff1cult to set appropnate non-linear access tariffs, leads to double margmahsation or allows the downstream producers to se1ze some of the monopoly profIts through access negohatlOns 11 8

Other arguments agaInst retaInIng vertIcally Integrdted regulated utIlItIes have been presented In the US and BntIsh lIterature See, for example, Brennan (1987), GeroskI, Thompson and Toker (1989), Noll and Owen (1989), and TemIn (1990) 9 A useful survey IS provIded by Vanan (1989) 10 See, for example, Ordover and Pdnzar (1980), (1982) and Schmalensee (1981) II A number of papers have conSIdered the relatIOnshIp between IntegratIOn and Incomplete contractIng wIth an upstream essentIal faCIlIty See Hart and THole (1990), McAtee and Schwartz (1994), and Rey and Tlrole (1996)

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King PRICE DISCRIMINATION, SEPARATION & ACCESS

The situation consIdered in this paper, which analyses the incentives for pnce discnmination by a regulated access provIder, has not receIved sigmficant attentlOn m the hterature despIte Its clear practical Importance. Gilbert and Riordan (1995) consider the welfare effects of separatmg a regulated integrated monopoly mto two vertically separate regulated fIrms. However, the focus of theIr work IS on the change m regulatory desIgn that accompanies structural reform and they do not consIder competitIOn m the fmal product market. The closest paper to ours m the hterature is VIckers (1995), which considers a similar model but only for constant margmal cost technology. VICkers also requires that the regulator set access prices through a regulatory revelatlOn mechanism (e.g. Baron 1989). Vickers shows that under free entry mtegratIOn/pnce discnmmatlOn may be eIther harmful or benefICIal to SOCIal welfare. HIs benefIts, like those presented below, arIse from more efficient entry.12 The loss occurs because of the feedback between integratIon and the regulated access pnce. While VIckers endogenises regulation m hIS model, It IS far from clear that the approach to regulation that he adopts will best model practical regulatory decislOns. In our model, we retam the same regulated access price regardless of the structure of the access proVIder If regulators set access pnces using, say, a rate-ofreturn procedure, then our assumption wIll be more realistIC than the one made by Vickers. IntegratlOn or vertIcal separatIOn should not affect the regulated access pnce. Further, because VIckers endogemses the regulated access price, it IS difficult to separate out the underlymg competItive forces that affect welfare The simpler approach to regulatIOn taken m our model allows us to focus on these competItive effects. For clarity of expOSItion, when presenting the model we focus on telecommunications. WhIle the model IS wntten for local network access, It clearly apphes to any situatIOn where a natural monopoly mput is used m final productlOn Thus, our results are equally valId for electriCIty, gas, water, rail and other utility mdustnes. Further, whIle we dIVIde production mto an upstream stage and a downstream stage, productlOn need not phYSIcally take thIS order. An example IS electrICIty productIOn, where generatlOn represents the second stage and dlstnbutlOn represents the natural-monopoly wholesale stage The analYSIS below IS unaffected by the order of productIOn so long as there IS competition m the sale of the final product (e.g. m the retail market for electncIty)

3.

The Model

A government WIshes to enhance competItion m telecommumcations. The productIOn of a telecommumcations product ll1volves a two-stage process. First, productlOn requires access to the local telephone network and this upstream (or 'wholesale') stage ll1volves a natural-monopoly technology. The second (downstream or 'retail') stage IS characterIsed by standard u-shaped average-cost technology. The final output IS a well-defmed, homogeneous good or serVIce To allow competitlOn WIthout mefficient duphcatIOn of the local network, fIrms can compete m the productIOn and sale of retml telecommumcatlOns products, and the 12

Because VIckers conSIders constant margmal cost production technology. hIS model does not allow for an mefflclent allocation of productIon over a fIxed number ot firms

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June 1999

upstream monopolist must supply these fInns with local network access at a regulated price. We wish to consider how competition m the retail stage of the production process changes as we alter the government's approach to deregulation. In partIcular, we wish to consider the effect on competitIOn of vertically separating the wholesale and retail parts of the monopoly owner of the local network and in so doing elImmating access pnce dlscrimmatIOn SeparatIOn wlll either reqUlre effective 'ring fencing' or a full separatIOn of ownership. If the government effectively separates the local network owner from retail productIOn then thiS finn will behave hke two separate companies, denoted by w and r. Fmn w will retam control of the local network and Will remam a (regulated) monopohst Finn r Will Simply be another competItor at the retall stage of productIOn FInn W Will not be allowed to compete at the retail stage Either w and/or r may be privately or publIcly owned and we will assume that they both (mdependently) seek to maximise their mdlvldual profits. Any regulation of w Will be carried out by a separate authority.13 As a counterfactual, we need to consider the SituatIOn where the government does not effectively separate the local network owner. In thiS case the network owner remams a smgle mtegrated producer, denoted by I FInn I Will retam ItS regulated monopoly in the first stage of the production process and will also be allowed to compete m the retail market The mtegrated finn mayor may not be privately owned and we wlll assume that it seeks to maximise ItS own profits subject to any regulatory constramts. For slmpliClty we assume that the marginal cost of local network access is constant and given by c To ensure the local network mvolves a natural monopoly technology, we assume that there IS a fixed cost W of estabhshillg/operatmg the local network so that average cost exceeds margmal cost and IS fallmg at all output levels We wish to consider the effect of differential access pncmg. Hence, the regulated pnce per umt of access, PH' Will be constant and set stnctly greater than C One umt of access IS required for each umt of the final good or service produced. However, if the local network owner IS integrated with a downstream producer, It Will make ItS own productIOn deCISions on the baSIS of the true margmal cost of access, CIt In other words, an mtegrated producer effectively charges Itself a stnctly lower access pnce than It charges other downstream producers Retail technology is charactensed by a per penod fixed cost of R > 0 and a vanable cost functIOn given by C(q) + p"q, where q IS the llldlvidual fmn's output. We assume that C(q) IS tWice contilluously differentiable with· H

•

H

,.

~o d e 2

de dq

>0

d(/ -

Vq~O

Let Q denote the total supply by all fInns mvolved m retail productIOn If the government does not vertically separate the local network owner then I'S cost functIOn IS simply the sum of the costs at the first stage of production for

13

A, recommended by the HIlmer report, p 237

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providing Q umts of access, W + cwQ and the additlonal costs of supplying Its individual output q, at the second stage, R + C(q) + Pwq, The mverse demand for the fmal good IS gIven by P(Q). We assume that P(Q) IS tWIce continuously differentlable wIth oP >0

oQ and:

;j2p oP -2Q+- q; but 2q: < m,q; .19 In other words, free entry Will lead to lower output by each firm but a lower pnce and more output overall Local network profits with free entry are given by (10)

and are stnctly greater under free entry than under lIcensed duopoly. 3.2

Licensed entry without separatIOn/with przce dlscrzmznatzon

We now consider the competItive ImplIcatIOns If the local network monopolIst IS able to set a dlscrimmatory access pnce for Its own downstream subsidiary. In this subsectIOn the case of a smgle lIcensed retail entrant IS analysed 20 In the next subsection we consider free entry at the retail level If there IS a smgle new entrant, e, at the retail level then the equilIbrium outputs of I and e, qll' and q,/ respectively, will simultaneously solve: 21 p( c/, + q,~) + p'( q:, + q,~ )(/, - C'( q:,) -

=0

(11)

p( q"'+ q"' ) + p'('q" + q"') q", - C'( q"') - p,,-- 0

(12)

c"

and

By our assumptIOns q;, and q;' are well defmed and ul1lque. By comparing equatIOns 11 and 12 with equatIOn 5, and given the negatIve slope of each retailers' best response function, It IS easy to confirm that q~ > q~ > q~ when P" > c" 22 19 To see these. note that If q:! 5 q/ then q,U < (III, - I )q/ whICh ImplIes thdt the optImal supply for any retml fIrm hdS fallen so thdt q,U > q! Thu; we have a contradIction Second. as q,U > q/, by ;ymmetry dnd the negatIve slope of each retaIler;' best response functIon, q,d < (Ill, - l)q! Let y > I be defIned by yq,U = (JIl, - I)q,l As the absolute slope of the reactIon functIon for each retaIler I; less than unIty, q/ > q,U _ (y _ I) q,U SubstItutIng tor y and rearrangIng gIves 2q,d < lIl,q/ 20 Thl; IS eqUIvalent to the 1980s telecommUnIcatIons reforms In the UK and the pre-1997 telecOmmUnICdtlons reforms In Austrdiia 21 These condItIon; .Ire denved from maxImIsIng equatIons I and 4 22 Sub;tJtutIon ;hows thdt It IS ImpOSSIble to hdve eIther q,,'S q,d and q,,' 5 q,d or q,,' ~ q,U dnd q,,' ~ q,d That q'" > l, > q'" and not vIce-versa follows trom the den\atlve ot the best-respom,e. q, for any retaIler WIth regard to the access prIce beIng gIven by 1I[2P'+P"q-C"1