Telecommunications

Regulation
Handbook
Module 4

Price Regulation

edited by
Hank Intven
 Telecommunications Regulation Handbook
Summary of Contents

Note: Detailed Tables of Contents appear at the beginning of each Module

Module 1 Overview of Telecommunications Regulation 1-1

Module 2 Licensing Telecommunications Services 2-1
Module 3 Interconnection 3-1
Module 4 Price Regulation 4-1
Module 5 Competition Policy 5-1
Module 6 Universal Service 6-1

Appendices

A WTO Regulation Reference Paper A-1

B The Economics of Telecommunications Prices and Costs B-1
C Glossary C-1
D Selected Sources D-1

© 2000 The World Bank

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First printing November 2000

ISBN 0-9697178-7-3
 Table of Contents

Module 4 – Price Regulation

4.1 Introduction 1
4.1.1 Objectives of Price Regulation 1
4.1.2 Rate Rebalancing 3

4.2 Approaches to Price Regulation 5

4.2.1 Introduction 5
4.2.2 Discretionary Price Setting 5
4.2.3 Rate-of-Return Regulation 6
4.2.4 ROR-Incentive Regulation 9
4.2.5 Types of ROR-Incentive Regulation 9

4.3 Price Cap Regulation 9

4.3.1 Overview 9
4.3.2 The Basic Price Cap Formula 10
4.3.3 Calculating Price Cap Variables: Looking Ahead or Back 13
4.3.4 The Inflation Factor 14
4.3.5 The Productivity Factor 17
4.3.6 Capped and Non-Capped Services 25
4.3.7 Service Baskets 25
4.3.8 Individual Service Pricing Restrictions 26
4.3.9 Duration and Review of Price Cap Plans 27

4.4 Price Cap Variations 29

4.4.1 Introduction 29
4.4.2 The Exogenous Factor 29
4.4.3 Quality of Service 30
4.4.4 New Services 32

4.4.5 Rate Rebalancing and Price Caps 32

4.4.6 International Accounting Rates 33

Appendix 4-1: OECD Rate Rebalancing 35

Appendix 4-2: Welfare Benefits of Rate Rebalancing 38

 Boxes, Figures and Tables

List of Boxes
Box 4-1:Weaknesses of Rate of Return Regulation 8
Box 4-2:Simplified Basic Price Cap Formula 10
Box 4-3:Using Price Indices - Simplified Calculation of API 12
Box 4-4:Basic Price Cap Formula Using Indices 13
Box 4-5:Selection Criteria for an Inflation Factor 15
Box 4-6:Alternative Inflation Factors 17
Box 4-7:Inflation Factor for Foreign Exchange Rate Changes 18
Box 4-8:Total Factor Productivity 19
Box 4-9:How Service Baskets Constrain Price Flexibility — Example 27
Box 4-10:
Examples of Unexpected Input Price Change Outside Control
of Regulated Operator 29
Box 4-11: What are Exogenous Cost Changes? 30
Box 4-12: OECD Tariff Comparison Methodology 35

List of Figures
Figure 4-1: Index of OECD Tariff Rebalancing by Distance,
including Local Calling 4
Figure 4-2: Index of OECD Business Charges and Teledensity 4
Figure 4-3: Price Cap Plan for Telecom Australia from 1989 to 1992 28
Figure 4-4: Price Cap Plan for Telecom Australia from 1992 to 1995 28
Figure 4-5: OECD Business Tariff Basket 36
Figure 4-6: OECD Residential Tariff Basket 36
Figure 4-7: Index of OECD Tariff Rebalancing, by year —
The “Death of Distance” 37
Figure 4-8: Index of OECD Residential Charges and Teledensity 37
Figure 4-9: Rate Rebalancing - Base Scenario 39

List of Tables
Table 4-1: Typical Result of Discretionary Price Setting 7
Table 4-2: Selected Estimates of TFP for the US. 21
Table 4-3: A Summary of British Telecom’ s Price Cap Plans 23
Table 4-4: X-Factors of Selected National Price Cap Regulation Plans 24
Table 4-5: X-Factors of Selected State Price Cap Regulation Plans in US 24
Table 4-6: Summary of Benchmark Estimates for Setting X-Factor (%) 25
Table 4-7: Service Coverage of Selected National Price Cap Regulation Plans 26
Table 4-8: Service Coverage of Selected Price Cap Regulation Schemes in US 26
Table 4-9: Q-Factor Example –Rhode Island Scheme 31
Table 4-10: Estimates Used in the Telstra Rate Rebalancing Model —
Base Scenario 38
Table 4-11: Results of Rate Rebalancing Scenarios 40
Telecommunications
Regulation
Handbook
Principal authors:

Hank Intven
Jeremy Oliver
Edgardo Sepúlveda

Funding for the preparation of this Handbook was provided

by the infoDev Program of The World Bank

Additional funding was provided by

Telecommunications Lawyers and Consultants

www.mccarthy.ca

The authors gratefully acknowledge the support and assistance provided

in the preparation of this Handbook
by the International Telecommunication Union (ITU)

The modules of this Handbook are available electronically at

www.infodev.org/projects/314regulationhandbook
 MODULE 4

PRICE REGULATION

4.1 Introduction 4.1.1 Objectives of Price Regulation

This Module discusses price regulation in the tele- Good price regulation mimics the results of efficient
communications sector. Before reading the Module, competition. However, price regulation may have
readers may want to review the section on the additional objectives. The objectives of price regula-
economic rationale for price regulation in the tele- tion may be grouped into three broad categories:
communications sector that is found in Appendix B
of the Handbook. As indicated in Section 1.1 of ➢ Financing objectives;
Appendix B, price regulation is normally justified
when telecommunications markets fail to produce ➢ Efficiency objectives; and
competitive prices.
➢ Equity objectives.
In this Module, we look more closely at the specific
objectives of price regulation and at the regulatory Financing Objectives
approaches used to achieve those objectives. The
basic approaches to price regulation have evolved An important objective of price regulation is to
with the transformation of the telecommunications ensure that regulated operators are permitted to
sector from monopoly to competition. As regulators earn sufficient revenue to finance on-going
have increasingly recognized the benefits of compe- operations and future investments. The minimum
tition, they have adapted price regulation to take amount of revenue associated with the financial
advantage of those benefits. objective is often referred to as the operator’s
“revenue requirement”. To mimic the effect of a
Today, price cap regulation is the most widely competitive market, the revenue requirement should
accepted form of price regulation in the sector. ideally match the amount required by an efficient
Because of its pre-eminence, a substantial part of operator to finance its operations and investments.
this Module is devoted to price cap regulation. This aspect of the financial objective may be
Before dealing with it, however, we discuss the ob- considered as setting a revenue “floor” for efficient
jectives of price regulation and review other operators.
approaches to price regulation, particularly Rate of
Return (ROR) regulation and its variations.

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Telecommunications Regulation Handbook

Some traditional forms of price regulation, including minimized because the actual output from the
Rate of Return regulation, do not allow operators to given inputs is less than what could be achieved.
earn revenues in excess of their revenue require-
ments. This aspect of the financial objective is Dynamic efficiency is achieved when resources
associated with preventing excessive revenues move over time to their highest value uses. Such
associated with monopoly or dominant market uses include efficient investment, improved
positions. It is discussed in greater detail in Sections productivity, research and development, and the
1.1 and 1.2 of Appendix B of the Handbook. This diffusion of new ideas and technologies.
aspect of the financing objective, which may be con- Dynamic efficiency involves the movement from
sidered a revenue “ceiling”, has been relaxed under one type of efficient use of resources to another
some specific conditions in other forms of price type of efficient use of resources.
regulation, particularly price cap regulation.
Equity Objectives
Efficiency Objectives
Equity objectives motivate many regulatory deci-
It is generally accepted that price regulation should sions on telecommunications prices. Equity
promote efficiency in the supply of telecommunica- objectives generally relate to the fair distribution of
tions services. However, efficiency can be measured welfare benefits among members of society. Tele-
in different ways. Three main aspects of efficiency communications regulators are primarily concerned
are discussed below. with two different aspects of equity in the regulation
of prices:
Allocative efficiency is achieved when the
prices of services reflect their relative scarcity. In Operator-consumer equity relates to the
an efficient market, prices will equal the marginal distribution of benefits between consumers and
cost of producing each service. In the telecom- the regulated operator. For instance, many
munications sector, prices of international and people would not consider it equitable that
long-distance services have traditionally been set monopoly operators be allowed to earn high
significantly above their costs while local calls are profits for an extended period of time without im-
priced below theirs. This is viewed as an proving or extending service. In this regard, the
example of allocative inefficiency. The above- aim of many regulators is to ensure that the
cost pricing of international services discourages savings that result from improved technological
consumption of such services. On the other innovations are shared equitably between the
hand, pricing local calls below cost encourages operator and consumers. Price cap regulation
consumption beyond the level at which local calls includes a mechanism for consumers to share in
can be economically provided. A more detailed these productivity gains.
discussion of allocative efficiency is presented in
Section 1.2 of Appendix B of the Handbook. Consumer-consumer equity relates to the
distribution of benefits between different classes
Productive efficiency has two related aspects. of telecommunications consumers. For example,
One aspect relates to the most efficient mix of in Colombia, consumers in lower socio-economic
inputs (capital, labour, etc.) for a given level of brackets pay less for the same local telephone
output. Some forms of price regulation can subscription services than consumers in higher
reduce productive efficiency. Rate of Return brackets. This approach implements a govern-
(ROR) regulation, for example, is generally ment policy aimed at improving consumer-
viewed as encouraging operators to use an inef- consumer equity.
ficiently high level of capital for its level of output.
A second aspect of productive efficiency requires Balancing the Objectives of Price Regulation
that the services be produced as efficiently as
possible, that is by minimizing all inputs. The The main challenges of price regulation involve the
related concept of x-efficiency describes a situa- design and implementation of low-cost and effective
tion in which an operator’s costs are not regulatory approaches that induce the regulated

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 Module 4 – Price Regulation

operator to achieve the socially desirable objectives therefore be under pressure to reduce subsidies or
discussed above. Regulation imposes a burden on risk losing customers in the more profitable market
the economy in the form of direct costs to segments. Traditional unbalanced price structures
telecommunications operators for enforcement and are also inefficient in that higher-than-cost prices
compliance. It may also place indirect burdens on encourage uneconomic entry by high-cost opera-
consumers in the form of loss of choice of operators tors. Lower-than-cost prices discourage economic
and/or services. A practical objective in the design of entry, even by low-cost operators.
price regulation approaches should be to impose the
least burden necessary to achieve their purposes. At Costs of different telecommunications services have
a minimum, benefits of price regulation should justify been decreasing at different rates as a result of
its costs. technological developments. This has further
unbalanced telecommunications prices. Where tele-
In practice, there is often disagreement over tele- communication markets are open to competition,
communications price regulation because the three prices of different services will tend to move towards
broad regulatory objectives, financial, efficiency and their costs. However, in monopoly or non-
equity, can conflict with one another. Some people competitive environments they may not, and the
will place more importance on one objective than regulator may be required to take steps to ensure
others. This means that the regulator will often have that prices are more closely aligned with costs.
to make trade-offs between these objectives in the Efficient monopoly pricing, and related matters, such
course of implementing price regulation. as Ramsey Pricing, are discussed in Sections 1.1
and 1.2 of Appendix B of the Handbook.
4.1.2 Rate Rebalancing
A significant amount of rate rebalancing has
This Section contains a brief discussion of price occurred in many industrialized countries in recent
rebalancing, or rate rebalancing, as it is more years. Comprehensive price comparisons have
frequently called. This important topic is dealt with in been conducted by the OECD for its 29 member
greater detail in Appendix 4-1 of this Module. countries since 1990. The effects of rebalancing
calls in member countries is presented in Figure 4-1.

Price Regulation
The term “rebalancing” refers to moving the prices As this figure illustrates, since 1990, the average
for different telecommunications services more price of local calls in OECD countries has risen by
closely in line with the costs of providing each more than 30%. In contrast, the average price of
service. Currently, telecommunications price struc- long distance calls (110 km and 490 km calls) has
tures in many countries are highly unbalanced, with decreased by about 30% over the same period.
some services priced well above costs and others
below costs. Telecommunications costing is Figure 4-2 shows the effect of rebalancing on prices
discussed in detail in Section 1.4 of Appendix B of for business services. Over the 1990-1998 period,
the Handbook fixed charges (connection and subscription)
increased by over 20% and usage charges
Prices of telephone connections, monthly subscrip- decreased by over 20%, for an overall weighted
tions, and local calls have traditionally been set reduction of about 12%. Note that overall teledensity
below costs in many countries. Resulting deficits in the OECD countries has increased steadily,
have been subsidized by higher-than-cost long despite rebalancing. The relationship between
distance and international calling prices. Some of rebalancing and consumer welfare is discussed
the historical reasons for these traditional pricing further in Module 6.
structures are discussed in Section 4.2.2.
These two figures and those contained in Appendix
Unbalanced price structures are not sustainable in a 4-1 indicate that rate rebalancing has produced
competitive environment. New competitors will lower overall prices for most consumers in a majority
generally enter those market segments where profit of the countries surveyed. However, this is not the
margins are highest, such as long distance and in- only benefit of rebalancing. Rate rebalancing will
ternational calling. Incumbent operators will also increase social welfare by moving prices closer

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Telecommunications Regulation Handbook

Figure 4-1: Index of OECD Tariff Rebalancing by Distance, including Local Calling

27 km 110 km 490 km Local Calling

150 150

140 140

130 130

120 120

110 110

100 100

90 90

80 80

70 70

60 60

50 50
1990 1991 1992 1993 1994 1995 1996 1997 1998
Notes: All indices set to 100 in 1990
Average weighted by number of access lines
Calculation based on PPP’s expressed in USD

Source OECD (1999)

Figure 4-2: Index of OECD Business Charges and Teledensity

T o ta l C h a r g e s Usa g e C h a rg e s F ixe d C h a r g e s T e le d e n s it y

130

120

110

100

90

80

70

60
1990 1991 1992 1993 1994 1995 1996 1997 1998
Notes: All indices set to 100 in 1990
Average weighted by number of access lines.
Calculation based on PPPs expressed in USD
Source: OECD (1999)

4-4
 Module 4 – Price Regulation

to costs. This is illustrated in more detail in Appendix principle assumes that a prospective buyer will pay a
4-1, and in other studies that have examined rebal- price that is related to the value derived from the
ancing in different countries. Rate rebalancing will service and that telephone services are more
provide benefits to the economy in addition to valuable to some classes of customers than to
producing lower overall prices. Therefore, there is a others. Accordingly, businesses are often charged
strong case to be made for rate rebalancing, with more than residential customers for the same
our without the introduction of competition. connection and subscription services. It is assumed
that businesses are major users of international and
4.2 Approaches to Price Regulation long-distance services, and that they value such
services highly. Accordingly, higher rates are
4.2.1 Introduction charged for such services.

Different approaches have been developed over the Discretionary price regulation approaches in many
years to regulate telecommunications prices. Some, countries were interventionist. Often the government
involving rules-based approaches, are designed to or the Minister in charge would micro-manage the
provide stability and certainty, as well as achieving PTT’s pricing structure, severely reducing its ability
regulatory objectives. Others have been more ad to function as a normal business enterprise. In some
hoc and discretionary. cases, telephone prices were increased to make up
government budget deficits, without extensive con-
This Section begins with a discussion of two sideration of the economic or social impacts of such
common pricing approaches: traditional discretion- increases.
ary price setting and Rate of Return regulation. This
Section is followed by a discussion on incentive In some countries, traditional discretionary price
regulation. In our analysis we consider how well the regulation failed to generate enough revenue to pay
three approaches achieve the broad objectives of the operating costs of the incumbent operator or to
price regulation: namely the financing, efficiency, support network upgrades and expansion. As a
and equity objectives. result, the operator’s revenue requirement and the
financial objective of regulation were sometimes not

Price Regulation
4.2.2 Discretionary Price Setting met.

Traditionally, in many countries, price regulation was In some jurisdictions, telephone revenues of state-
focussed heavily on social objectives as well as owned operators were treated as part of general
financial or economic ones. This was particularly government revenues. Expenditures of the state-
true where the government operated the telecom- owned operator, including those for investments, are
munications network. Under such circumstances, included in the general government budget. Poor
prices were usually set to promote consumer-to- government fiscal management made it impossible
consumer equity objectives. In many countries, there to meet a PTT’s revenue requirement. Such an
was little or no analysis of the economic impacts of arrangement deprives the operator of the capital
such policies. required to upgrade its network. It can also reduce
the incentive for the operator to innovate and reduce
costs, which hurts the dynamic efficiency objective.
Where discretionary price regulation existed, or
In practice, such operators often have poor perform-
continues to exist, it is usually characterized by
ance and over-staffing, which means that the
below-cost prices for connection, subscription and
productive efficiency objective is not met either.
local calls. The shortfall is made up by higher-than-
cost international call prices, and sometimes also
high long-distance prices. Long-term capital investments should make up a
large part of the costs of a telecommunications
operator. However, cash-strapped governments
The frequently-stated objective of this type of pricing
sometimes extract cash from state-owned operators
is to promote affordability of basic telephone serv-
to finance other government priorities. This has been
ices. This type of pricing may also incorporate the
more common where there was no explicit rules-
value of service principle. Simply stated, this

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Telecommunications Regulation Handbook

based regulatory regime that requires prices to be 4.2.3 Rate-of-Return Regulation

set to meet a revenue requirement calculated to in-
clude long-term capital investments. Enough cash Rate of Return (ROR) regulation is a rules-based
may be left for the operator to meet its day-to-day form of price regulation. Unlike discretionary price
operating requirements, but not enough to upgrade setting, ROR regulation provides an operator with
or expand the network. relative certainty that it can meet its revenue
requirement on an ongoing basis. The essence of
Where this has happened, the result has been an ROR regulation is simple. First, the regulated
undersupply of telecommunications services and operator’s revenue requirement is calculated. Then
waiting lists for service. In some countries, telecom- the operator’s individual service prices are adjusted
munications prices have been increased solely to so that its aggregate service revenues cover its
meet general government revenue requirements, revenue requirement.
without regard to the specific revenue requirement of
the telecommunications operator. Instead of In calculating the revenue requirement, the regulator
improving telecommunications service, the proceeds first reviews the operating costs and financing (e.g.
of telephone rate increases have sometimes been debt service) costs. Typically there is some regula-
used to meet a wide range of other government tory scrutiny to ensure that the costs were
priorities, from subsidizing postal services to paying necessarily and prudently incurred in order to
the armed forces. provide the regulated services. If not, they may be
disallowed from the “rate base”. The operator will not
In some cases, it is said that local telephone rates be entitled to increase its prices or rates to recover
are kept at low levels to maintain affordability of such disallowed costs.
services for low-income subscribers (i.e. to meet
consumer-consumer equity objectives). In reality, The next step in calculating an operator’s revenue
however, the initial telephone users in most emerg- requirement is to determine its rate of return. In
ing economies are not the poor. With low prices, the order to allow the operator to remain financially
relatively privileged group of telephone users end up viable, and to attract new capital for its operations,
paying much less than it can afford. At the same ROR regulation permits the operator to recover not
time, the operator cannot expand the network to only its direct operation and financing costs, but also
provide service to other users. This undermines the a fair return on its rate base. The regulator deter-
operator-consumer equity and consumer-consumer mines an appropriate rate of return on capital for a
equity objectives. As a result, most of the poor given time period (typically one to three years). This
households, especially in rural areas, receive no return is generally based on a review of financial
subsidy at all because they have no access. In market conditions, plus any additional operator or
summary, experience has shown that discretionary industry-specific issues (industry or operator risk,
price setting approaches have seldom achieved operator specific taxation issues, etc.).
their social or economic goals, at least on a long-
term basis. Based on the approved rate of return, a revenue
requirement is calculated (i.e. total revenues that
Traditional discretionary price setting approaches may be generated in a given period). The revenue
have usually resulted in inefficient price structures. requirement is to be recovered from the sum of all
Table 4-1 summarizes the main differences between services provided. If an operator earns more than its
prices that typically result from discretionary price allowable rate of return, the regulator will require
setting and the types of cost-oriented prices that price reductions to bring the operator’s rate of return
would result from competition. down to the allowable level. Conversely, if the
operator does not meet its allowable rate of return, it
A detailed discussion of telecommunications costs is will request price increases to raise its revenues.
provided in Section 1.4 of Appendix B.

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 Module 4 – Price Regulation

Table 4-1: Typical Result of Discretionary Price Setting

Service Discretionary Price Setting Efficient Cost-oriented Pricing

Connection Very low price: typically below $50. Related to the incremental costs of providing the line.
Waiting list used to ration demand.
Subscription Relatively low price: typically below Related to the incremental costs of local service,
$3/month. Network congestion including the local exchange switch and the "local
used to ration demand. loop" portion of the network. Local service costs vary
significantly across different service areas, based on
density and other factors. Higher charges levied on
businesses due to their higher demands for main-
tenance and service quality.
Local Calling Very low, unmetered or non- Calls charged per minute and in some cases with
existent local call charges. additional call set-up surcharge. Discounts for off-
peak calling and special promotions.
Domestic High charges with multiple call Calls charged per minute with possible reductions for
Long- zones. Longest distance typically duration of call. Discounting during off-peak periods.
distance charged at a multiple of 20 or more Ratio between longest-distance call and local call in
Calling times local call rate. range of five to one or less. Tendency to distance-
insensitive or “postalized” prices.
International Generally very high, especially to Calls charged per minute with possible reductions for
Calling distant countries. Accounting rates duration of call. Discounting during off-peak periods.
kept high and number of outgoing Ratio between international and national calls
circuits kept low to generate net typically in excess of 3 to 1, but coming down due to
settlement payments. accounting rate reform.

Price Regulation
Source: Adapted from ITU (1998a)

ROR regulation is designed to equate an operator’s the efficiency objectives of price regulation as well
total revenues with its total costs. It is generally not as other forms of regulation.
designed to equate revenue for any particular
service to the cost of that service. As a result, it does The perceived inefficiencies of ROR regulation must
not specifically address the structure of prices. In be put into perspective. The reality is that operators
practice, where ROR regulation is applied, the in some industrialized countries performed relatively
structure of prices generally tends to fall somewhere well under ROR regulation for nearly a century, tak-
between cost-oriented prices and the prices that ing advantage of gains in technology and sharing
result from discretionary price setting. the benefits with their customers in the form of lower
prices. Nevertheless, because of the identified
Weaknesses of ROR Regulation weaknesses, many regulators in industrialized
countries have been introducing forms of incentive
The weaknesses of ROR regulation are summarized regulation instead of ROR regulation.
in Box 4-1. The main weakness is that it does not
provide operators with a strong incentive to operate Concerns about the inefficiencies of ROR regulation
efficiently by reducing their operating costs. They arose in industrialized countries after extensive
can usually recover most if not all of their costs networks had been constructed. The most important
through rate increases, and they are not permitted to objective in many developing countries is to build
retain additional profits earned by reducing their network infrastructure to meet unsatisfied demand.
costs. As a result, ROR regulation does not promote

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Telecommunications Regulation Handbook

Box 4-1: Weaknesses of Rate of Return Regulation

Lack of Incentive to Minimize Costs

➢ In ROR regulation, the operator’s prices are set at a level sufficient to cover its costs. This is why
ROR regulation is often referred to as “cost plus regulation”. From a dynamic perspective,
therefore, the operator has little incentive to reduce its rate base or its operating costs. In
competitive markets, where the market determines price levels, an increase in costs will reduce
profits. Therefore cost containment is a major objective of operators in a competitive market.

Lack of Innovation/Productivity Improvement

➢ Over time, ROR regulation of a monopoly operator will lead to a lower rate of productivity improve-
ment than would occur under effective competition. ROR regulation does not provide the operator
with a strong incentive to increase its productivity.

Capital Bias – The Aversch-Johnson Effect

➢ ROR regulation provides incentives to increase the amount of capital that the operator invests. The
higher the capital expenditure, the higher the rate base, and the greater the total return the
operator can earn. It therefore encourages the operator to use an inefficient input mix. The
operator will have an incentive to use an inefficiently high capital/labour ratio for its level of output.
This result is often referred to as the Aversch-Johnson effect, named after two economists who
described it. The effect is an indication that productive efficiency is not being maximized.

Cost of Regulation
➢ ROR regulation requires the operator and the regulator to spend significant amounts of time and
money. The rate base must be repeatedly calculated by the operator and reviewed by the
regulator, the cost of capital must be recalculated, and so on. Rate reviews or hearings must be
held on a regular basis, incurring costs to the regulator, the operator, and other participants in the
process.

Interventionist Nature of ROR Regulation

➢ The regulator is required to review many aspects of the operation and management of the firm in a
detailed manner. This includes scrutiny to prevent rate base “padding”. Over time, this type of
detailed regulation may place a regulatory burden on the firm that impedes its ability to function as
a normal business enterprise.

Inadequacy for Transition to Competition

➢ ROR regulation operates relatively slowly, and generally does not allow operators the pricing
flexibility they need to respond to competitors’ actions.
➢ The introduction of competition in some parts of the telecommunications sector, combined with
continuing ROR regulation in monopoly segments, means that vertically-integrated operators have
an incentive to engage in anti-competitive practices (e.g. anti-competitive cross-subsidization).

This will typically require a very large capital invest- minimizes the differences between ROR and incen-
ment. As a result, the concern about ROR regulation tive regulation. In fact, any economically sustainable
emphasizing capital investment is not as significant form of rules-based price regulation would be
a concern in developing countries. The political and preferable to the ad hoc forms of discretionary price
economic environment in many developing countries

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 Module 4 – Price Regulation

setting currently practised in some developing similar to those created by traditional ROR regula-
countries. tion. A broad band of earnings can create stronger
incentives for the operator to reduce operating costs
4.2.4 ROR-Incentive Regulation and improve operations. For instance, rather than
set the rate of return at 12%, the operator might be
The term ROR-incentive regulation is generally used allowed a return of between 10% and 14%.
to describe variations on ROR regulation that were
developed in different US states to respond to Rate Case Moratoria
perceived weaknesses in traditional ROR regulation.
ROR-incentive regulation has enjoyed limited Rate case moratoria can be implemented by
popularity in other parts of the world. agreements between a regulator and an operator to
suspend regulatory scrutiny of the operator’s
Incentive regulation provides inducements and pen- earnings for a fixed period. This form of incentive
alties that encourage an operator to meet regulatory regulation is often used at the beginning of a transi-
goals. tion to price cap regulation. It gives the regulated
operator an incentive to lower operating costs, since
The different types of incentive regulation generally it may retain higher earnings during the transition
share the following elements: period.

➢ The operator often participates in setting goals Earnings-Sharing

or performance targets.
Under an earnings-sharing plan, the operator may
➢ The operator is given more flexibility than under retain higher earnings. However, earnings in a
traditional ROR regulation. The regulator specified range are shared with consumers.
typically does not prescribe specific manage- Typically, these plans are set up with different
ment actions. For example, the operator may be sharing ranges based on a prescribed ROR. These
rewarded for reducing its operating costs but not sharing ranges can differ substantially from plan to
told exactly how to reduce these costs. plan. In one example of this type of plan, the

Price Regulation
regulated operator keeps 100% of the earnings up
➢ The regulator restricts some activities of the to 10%, the operator and consumers split earnings
operator. between 10% and 14%. The operator’s earnings are
capped at 14%.
➢ Rewards and penalties established by the
regulator motivate the operator to perform 4.3 Price Cap Regulation
efficiently.
4.3.1 Overview
4.2.5 Types of ROR-Incentive Regulation
This Section provides an overview of price cap
In this Section, we summarize some of the incentive- regulation, which is the preferred form of rules-
based regulatory schemes that have been based price regulation around the world today.
implemented in the US telecommunications industry.
These forms of regulation typically replace traditional Price cap regulation uses a formula to determine the
ROR regulation. maximum allowable price increases for a regulated
operator’s services for a specified number of years.
Banded Rate-of-Return The formula is designed to permit an operator to
recover its unavoidable cost increases (e.g. inflation,
Under this form of incentive regulation, regulators tax increases, etc.) through price increases.
establish a range (or band) of authorized earnings. However, unlike ROR regulation, the formula does
Prices are set to generate earnings that fall within not permit the operator to increase rates to recover
the authorized range. When only a narrow band of all costs. The formula also requires the operator to
earnings is permitted, the operator’s incentives are lower its prices regularly to reflect productivity

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Telecommunications Regulation Handbook

increases that an efficient operator would be 4.3.2 The Basic Price Cap Formula
expected to experience.
There are a number of ways to express the price
Price cap regulation has several advantages over cap formula. In its simplest form, a price cap formula
ROR regulation: allows an operator to increase its rates annually by
an amount equal to an inflation measure, less an
➢ It provides incentives for greater efficiency; amount equal to the assumed rate of productivity
increase. A simplified very basic price cap formula is
➢ It streamlines the regulatory process; set out in Box 4-2.

➢ It provides greater pricing flexibility; It can be seen from this simple example that opera-
tors may increase their prices to include the effects
➢ It reduces the possibility of regulatory interven- of inflation, but no more. Inflationary cost increases
tion and micro-management; of 5% may be passed on because it is assumed that
the operator cannot control them. However, the
➢ It allows consumers and operators to share in example also assumes that telecommunications
expected productivity gains; industry productivity will increase by 3%. Such pro-
ductivity increases result from technological
➢ It protects consumers and competitors by limit- improvements, lower switching and transmission
ing price increases; and costs, and many other factors. Therefore, in the
above example, the operator must pass on a
➢ It limits the opportunity for cross-subsidization. productivity benefit to its customers by lowering its
year 2001 prices by 3%.
For these advantages to materialize, price cap
regulation must be implemented in an effective and In this example, the operator may reap the benefits
internally consistent manner. We discuss some of of any measures it takes to reduce its costs below
these implementation challenges in the Sections 3%. If the operator has been very efficient, it may
below.

Price cap regulation is meant to provide incentives Box 4-2: Simplified Basic Price Cap
that are similar to competitive market forces. Com- Formula
petitive forces require operators to improve
productivity and, after accounting for unavoidable Allowable price increase for a year = Starting
increases in their input costs, pass these gains on to Price + I – X
their customers in the form of lower prices. The price Notes:
cap formula has a similar effect.
(1) I = Inflation Factor for the year
Price cap regulation is a means to regulate prices (2) X = Productivity Factor
over time. The price cap formula determines the rate
of change in prices from an initial level. The initial (3) These factors are discussed in greater
detail in later Sections of this Module
level of prices may be set by the regulator (see Sec-
tion 4.1.2). Alternatively, the regulator may establish Example:
a transition period at the end of which the regulated In year 2000, the price is 100
operator must reach target price levels or ranges
(see Section 4.4.5). Future financial performance for I =5
a price cap regulated operator formulae is highly X=3
dependent on the initial price levels. Therefore, it is
critical for the regulator to ensure that the initial level Therefore, the allowable price increase for
2001 equals 100 + 5 – 3 = 102
of prices are consistent with the operator’s revenue
requirement.

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 Module 4 – Price Regulation

have reduced its actual costs by 10%. In such a These simple examples illustrate the following basic
case, the operator may retain the benefits of features of price cap formulae that are based on
lowering its costs from the assumed 3% productivity indices:
factor to 10%. The additional earnings which result
from such efficient operations may be retained as ➢ The actual prices of the operator (as measured
profits to shareholders or used for other purposes, by the API) may not exceed the price cap for the
such as new investment. The earnings could also be year (as measured by the PCI).
used to reduce prices further, for example to meet
competition. However, such additional reductions ➢ The operator has pricing flexibility; some prices
will not be required by the regulator. The price cap may be increased above the weighted average
formula determines the maximum required price of the change in prices, as long as others are
decreases. not.

4.3.2.1 Price Indices and Weights ➢ Prices for services with heavier weightings in an
index will affect the index more. Therefore,
The sample price cap formula in Box 4-2 is highly prices for major services (measured by
simplified. In practice, telecommunications operators revenues) may not be increased as much as
do not offer a single service at a single price. They prices for less significant services.
offer a range of different services at different prices.
A typical price cap formula will, therefore, generally 4.3.2.2 Basic Indexed Price Cap Formula
use an index of the prices charged by an operator
and not a single price. In such cases, the operator Box 4-4 restates the basic price cap formula using
will be required to keep its actual prices below a the concept of price indices described above. The
Price Cap Index (PCI). formula assumes that prices will be calculated for
each year. The symbol “t” is used in the formula to
In developing indices for a price cap formula, prices represent the appropriate time period (e.g. a year).
of different services are weighted so that the prices In practice, different time periods can be used in-
for major services receive a proportionately greater stead of years.

Price Regulation
weight. Consider a simple example, where an
operator provides only two services, local service The factors I and X which are used in the formula
and international service. An index of the operator’s set out in Box 4-4 are discussed in greater detail in
actual prices (Actual Price Index or API) can be later Sections of this Module.
developed for this operator using service revenues
as weights. For example, assume that local service 4.3.2.3 Service Baskets
accounts for 75% of the operator’s revenues, and
international service accounts for 25%. The same Under price cap regulation, services are usually
proportions (“weights”) will be used to determine grouped into one or more service baskets. Different
whether the operator’s API exceeded the price cap, service baskets may be subject to different price cap
or PCI. indices.

Let us use the same price increase assumptions as For example, a residential service basket might be
described in Box 4-2. In the year 2001, prices will be developed to limit price increases affecting residen-
allowed to increase from 100 to 102. Therefore, let tial consumers. This basket might include local
us assume that 102 is the PCI. To determine residential connection charges, monthly subscription
whether the operator’s actual prices in 2001 exceed fees, and local and international usage charges. A
the PCI of 102, we must compare that PCI to the separate basket might include services used by typi-
API. Box 4-3 contains examples comparing the cal business customers.
operator’s API for 2001 to its PCI of 102.

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Telecommunications Regulation Handbook

Box 4-3: Using Price Indices - Simplified Calculation of API

Basic Price Cap Rule: API @ PCI

i.e. the Actual Price Index (API) for the year 2001 must be equal to or less than the Price Cap Index (PCI)
for 2001. The objective of this example is to calculate the API for year 2001 and determine whether the
proposed price changes comply with the Basic Price Cap Rule. The API for year 2001 is the product of the
API for year 2000 and the weighted average of the change in prices from 2000 to 2001.
Notes:
(1) Set the API, the PCI and all prices equal to 100 in year 2000
(2) Year 2001 PCI = 102 (i.e. a 2% increase over year 2000)
(3) Indices are weighted by revenues
(4) The operator provides only 2 services:
(a) Local Services = 75% of revenues
(b) International Services = 25% of revenues
(5) The weighted average of the change in prices is the sum of the following calculation for each service:
the change in prices (expressed as the division of year 2001 price by year 2000 price) multiplied by the
respective revenue weight (expressed as the division of service revenue by total revenue).

Example A:
Proposed price changes: Local price increases by 1% from year 2000 to 2001 (100 to 101)
International price increases by 4% from year 2000 to 2001 (100 to 104)

Weighted average of the Local service: 1.01 x 0.75 = 0.7575

change in prices: International service: 1.04 x 0.25 = 0.2600
Total: = 1.0175
Since the API for 2000 was 100, the API for 2001 is the product of 100 and the weighted average of the
change in prices, i.e. 100 x 1.0175 = 101.75. Therefore API < PCI (i.e. 101.75 is less than 102). Since the
proposed year 2001 prices are less than the PCI, no additional price reductions would be required by the
regulator.
Example B:
Proposed price changes: Local price increases by 4% from year 2000 to 2001 (100 to 104)
International price increases by 1% from year 2000 to 2001 (100 to 101)

Weighted average of the Local service: 1.04 x 0.75 = 0.7800

change in prices: International service: 1.01 x 0.25 = 0.2525
Total: = 1.0325
Since the API for 2000 was 100, the API for 2001 is the product of 100 and the weighted average of the
change in prices, i.e. 100 x 1.0325 = 103.25. Therefore API > PCI (i.e. 103.25 is greater than 102). Since
the proposed year 2001 prices are higher than the PCI, the proposed prices would not be approved by the
regulator. The regulator would require that prices must be reduced further.

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 Module 4 – Price Regulation

Box 4-4: Basic Price Cap Formula Using Indices

Price cap regulation requires:

t t
API @ PCI for all t
That is, the API for a particular time period must always be less than or equal to the PCI for that period. From
year to year, the PCI is adjusted according to the following formula:
t t-1 t
PCI = PCI x (1 + I - X)
i.e. the PCI for a given year (t) will be equal to the PCI for the previous year (t-1) multiplied by 1 plus the Infla-
t
tion Factor for year t (I ) minus the Productivity Factor (X).
Notes:
t
(1) API means the Actual Price Index at year t. The API is a weighted average of the change in prices
actually charged by the operator.
t
(2) PCI means the price cap index at year t. The PCI is a weighted average of the change in the
maximum allowable prices of the operator.
t
(3) I is the inflation factor at time t.
(4) X is the productivity factor.
t
(5) It is common to express I and X in percentage terms especially when referring to them outside the
context of actual price cap calculations. Note, however, that in the price cap formulae these variables are
expressed in decimal, not percentage terms.
Example
Using the same PCI assumptions as described in Box 4-2 and Box 4-3, in a period where the inflation
factor is 5% and the productivity factor is 3%, the maximum amount that the weighted average of the

Price Regulation
change in prices would be permitted to increase would be by 2%.
t t-1 t
i.e. The formula PCI = PCI x (1 + I - X) produces the following result: 102 = 100 x (1+.05 -.03)

There may also be restrictions on the absolute or of service open to competition (e.g. domestic and
relative movement of prices for services subject to international long distance) by monopoly services
price cap regulation. Operators may change prices (e.g. access and local calling).
for individual services within the baskets as long as
the API for the services in the basket complies with 4.3.3 Calculating Price Cap Variables:
the price cap formula, and as long as no individual Looking Ahead or Back
service pricing restrictions are breached.
The basic price cap formula contains a number of
An example of an individual service pricing restric- variables that must be calculated. To mimic the
tion is a rule that no price for an individual service workings of competitive markets, the price cap
may increase by more than 10% per year. Such formula should ideally be forward-looking. Variables
restrictions may be applied, for example, to limit the such as the inflation (I) and productivity (X) factors,
impact on residential consumers of rate rebalancing. and the weights used to calculate the indices should
The concepts of service baskets and individual ideally be determined based on expected future
restrictions are discussed further in Sections 4.3.7 values.
and 4.3.8 of this Module. Service baskets may also
be used to restrict or prevent the cross-subsidization

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Telecommunications Regulation Handbook

In practice, however, the majority of regulators only Another approach is to set fixed weights that do not
set the productivity factor based on future values. vary from period to period. This approach is
The inflation factor and index weights are administratively simpler and limits any possibility for
determined based on the most recent available the operator to manipulate the price cap formula by
historical data. setting prices strategically. Setting weights based on
forward-looking cost benchmarks is one possible
There are a number of practical reasons for setting alternative under this approach.
the inflation factor and index weights based on
historical data: 4.3.4 The Inflation Factor

➢ In many economies, past inflation performance The price cap formula includes an inflation factor to
is a good predictor of future inflation. account for changes in input costs of the operator.
For example, holding all the other variables
➢ The process of forecasting inflation and the de- constant, a 5% inflation factor would allow a
mand and revenue variables needed to forecast regulated operator to increase its average prices by
weights is complex, time consuming, and 5%.
subject to controversy and possibly
manipulation. 4.3.4.1 Selection Criteria

➢ A forecasting approach may necessitate In most economies, a number of different indices are
corrections to offset the effect of forecasting used to measure inflation. For example, a consumer
errors, thus adding complexity and regulatory price index or retail price index (CPI or RPI) meas-
uncertainty. ures changes in the prices of goods and services
purchased by typical consumers (e.g. food,
Basing the inflation factor and weights on historical passenger transportation, residential electrical
data also has disadvantages. For instance, future power, etc.). A Producer Price Index (PPI) measures
inflation may vary significantly from past inflation. changes in the prices of goods and services
This disadvantage may be mitigated by increasing purchased by different types of production industries
the frequency of adjustments to the inflation factor, (e.g. prices for labour, freight transport, industrial
or by establishing trigger mechanisms as discussed electrical power, etc.).
below.
In developing a price cap formula, regulators must
In principle, index weights may be based on costs or select an appropriate inflation factor (I). A choice
revenues. Cost weights are generally considered to may be made from among existing inflation indices,
be the more theoretically correct choice, but reliable or a new inflation factor may be calculated.
forward-looking costing data is often not available. In Regulators that have implemented price cap regula-
practice, therefore, most regulators have chosen tion have identified a number of criteria for selecting
revenue weights to calculate the aggregate indices an inflation index to be used as the inflation factor.
in the price cap formula. Regulators should be espe- Frequently used criteria are set out in Box 4-5.
cially vigilant in the choice of weights when prices
are not balanced and heavy cross-subsidization Particular national circumstances may dictate that
exists. In this type of scenario there may be other criteria should be considered. It is unlikely that
significant differences in the cost and revenue any one potential inflation measure will rank highest
weights and use of the latter may bias the in all of the selection criteria. Ultimately, the selection
calculation of the API. must be based on the informed judgment of the
regulator.

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 Module 4 – Price Regulation

Box 4-5: Selection Criteria for an Inflation Factor

Reflective of changes in the operator’s costs

➢ For the inflation factor to be a useful variable, it must reflect changes in the operator’s input costs.
This is particularly critical in situations of economic instability, when the inflation factor will have to
capture sudden and large changes in the country’s exchange rate. This is particularly important for
operators that typically purchase a large proportion of their equipment in foreign currency.

Availability from a credible, published, independent source

➢ This is important if price cap regulation is to have credibility with all parties involved. Private sector
participants as well as international investors in the sector must be able to trust the source of the
data.

Availability on a timely basis

➢ In order for the price cap formula to respond quickly to any changes in input costs, the inflation
factor should ideally be available with a lag of less than 6 months and preferably 2 to 4 months.

Understandability
➢ There is significant benefit in including an inflation factor that is easily understood not only by all
the players in the telecommunications sector, but by the public at large.

Stability
➢ The values of some statistical indices are subject to revision after their initial release. For example,
in March 2001, the January 2001 CPI may be announced at 123.47; however, that value may be
revised to 123.58 in June 2001. If possible, an inflation factor should be chosen that is not subject
to large frequent revisions.

Price Regulation
Consistency with total factor productivity of the economy
➢ The choice of price index will have a direct impact on the manner of calculating the productivity
factor (X) because efficiency gains in the rest of the economy affect the operator through this
index. As we discuss below, the inclusion of specific variables in the price cap formula will depend
on whether an economy-wide price index or a price index for the operator's principal inputs is
used. This aspect is discussed in greater detail in Section 4.3.5.

4.3.4.2 Potentially Useful Inflation Indices Potentially useful inflation measures may be classi-
fied as either economy-wide indices or non-
With these selection criteria in mind, the next step is economy wide price indices. Some inflation
to examine existing inflation measures available in measures are designed to reflect national or
the country. A number of indices are normally pub- domestic output price changes. For example, the
lished by or available from the government statistical Gross Domestic Product (GDP) price index
office (if one exists), and/or the country’s central measures the cost of a fixed basket of goods and
bank. In some countries, these statistics are services that make up the GDP in a particular base
produced by government ministries, such as the year. This is updated at periodic intervals. Similarly,
Ministries of Finance, Statistics, Planning or the price index for the Gross National Product (GNP)
Economic Development. gives economy-wide coverage.

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Telecommunications Regulation Handbook

A related index is the GDP or GNP deflator. Tradi- sider the advantages and disadvantages of each
tionally, the deflator is determined by dividing the available index as a potential inflation factor. It is
cost of the basket of goods and services that make possible that the regulator will decide that none of
up the GDP (or GNP) at current prices by the cost of the existing national indices is appropriate. Box 4-6
the same basket at constant prices. Hence, the presents some possible alternative inflation factors.
deflator reflects not only pure price changes, but
also changes, if any, in the weights attached to the 4.3.4.4 Period of Adjustment
GDP (or GNP) components.
The regulator must decide how often changes in the
The GDP (and GNP) indices and deflators are chosen inflation index will be used to adjust the price
broadly based. They reflect changes in the prices cap formula, and how often the operator will be
affecting a large basket of goods and services. Many allowed to adjust its rates. This is referred to as the
regulators in the U.S. and Canada have chosen one periodicity of adjustment to the price cap formula. In
of these economy-wide indices as the inflation factor industrialized countries, the period of adjustment is
to be included in their price cap formula. usually once a year. This is a feasible option be-
cause inflation rates tend to be relatively low and
Other indices are narrower in scope. For example, stable in such countries.
the Consumer Price Index (CPI) or the Retail Price
Index (RPI) measures the changes in prices paid by Many developing countries, however, are subject to
consumers. They typically measure the cost of a greater economic instability. Hence, the ideal perio-
fixed basket of goods and services that are bought dicity may be less than a year, say 3 or 6 months. A
by consumers in a particular base year, and update relatively short period between updates lessens the
it at periodic intervals. This narrow scope is their impact that an acceleration or deceleration of
greatest disadvantage because telecommunications inflation can have on the operator’s expenses. The
operators incur only a portion of their costs in retail regulator should weigh the benefits of frequent
consumer markets. Hence, the CPI or RPI may be adjustment against the administrative costs of
relatively poor indicators of inflation affecting the changing and publishing new prices on a regular,
operator’s cost structure. short-term basis.

Another set of inflation measures that is narrower in 4.3.4.5 I-Factor Adjustment Mechanism
scope are the producer, industrial or wholesale price
indices. Generally, they measure changes in prices One approach developed to deal with economic
paid by companies economy-wide, or in particular instability is to include a trigger mechanism in the
sectors of the economy. adjustment of the price cap formula. Under this
approach, the regulator may select a standard
A number of regulators in the United Kingdom and national inflation index as its inflation factor with a
Europe have selected retail price indices as the relatively long period of adjustment. However, as a
inflation factor to be included in their price cap “fall back”, an immediate adjustment may be made
formula. In fact, price cap regulation is sometimes to the inflation factor in the event of certain large and
referred to as “RPI-X” regulation, referring to the unexpected economic developments.
initiative of the United Kingdom in first implementing
this type of regulation in the early 1980s, when As an example, an adjustment might take place
British Telecom was privatized. when the selected national inflation index increases
or decreases by a significant amount. In countries
4.3.4.3 Other Inflation Factors with a history of relatively low and stable inflation,
this amount could be in the order of 10% to 20%.
Based on the general criteria set out above and on a
survey of existing indices, the regulator should con-

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 Module 4 – Price Regulation

Box 4-6: Alternative Inflation Factors

➢ One option is to use an inflation index from another country (or inflation measures produced by
United Nations organizations and/or international financial institutions, regional development banks,
The World Bank, the IMF, etc.).
➢ In Argentina, for instance, some regulated utilities use the producer price index for the United
States. This is then converted into the national currency. This choice was designed to reassure
foreign investors by relating their revenues to a hard currency.
➢ Another option is to construct a new measure of inflation that more accurately reflects the cost
structure of the operators. This new “composite” index may be a weighted combination of several
existing indices.
➢ In Colombia, for instance, the interconnection access rates paid by wireless and long distance op-
erators to local telephone operators is indexed on a monthly basis to a composite index made up
of the following:
➢ An index of the US/Colombia exchange rate and the average customs duty; weight: 0.38
➢ An index of the minimum industrial wage in Colombia; weight: 0.29
➢ The Producer Price Index of Colombia; weight: 0.33
➢ Similarly, in Chile, the access rates paid by mobile operators to terminate calls on the networks of
PSTN operators is indexed on a monthly basis to a weighted aggregate index made up of the
following:
➢ An index of the imported goods and services component of the Chilean wholesale price
index; weight 0.263
➢ The Chilean wholesale price index; weight: 0.542
➢

Price Regulation
The Chilean consumer price index; weight: 0.195
Source for Argentina example: Green and Pardina (1999)

An I-Factor adjustment mechanism can also be tied consumers receive partly or fully the benefits of the
to other key changes that would seriously impact on operator’s expected productivity gains in the form of
the cost of operating a telecommunications system. lower prices. For example, if all other variables are
In many countries, the most serious potential held constant, a 3% X-factor will result in annual
change is a devaluation of the national currency. reductions of 3% in average consumer prices.
While this may reduce labour costs, it can signifi-
cantly increase the costs of equipment, foreign The proper choice of an X-factor is critical for the
consulting services, financing charges, etc. An long-term viability of any price cap plan. Selecting
adjustment mechanism to deal with this type of the X-factor is often the most contentious aspect of
change is presented in Box 4-7. implementing price cap regulation. The X-factor
should be set so that it poses a challenge to the
4.3.5 The Productivity Factor operator. It should promise consumers higher gains
relative to alternative regulatory regimes. If the X-
The price cap formula includes a productivity factor, factor is set too low, the operator will earn excessive
which is based on an estimate of the operator’s ex- profits and the regulatory regime could fall into
pected productivity increases over the relevant disrepute. If too large an X-factor is selected, the
period. This variable, commonly referred to as the operator may not be permitted to meet its revenue
“X-factor” or the “productivity offset”, ensures that requirement.

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Telecommunications Regulation Handbook

Box 4-7: Inflation Factor for Foreign Exchange Rate Changes

A mechanism to adjust the inflation factor in a price cap formula can be triggered by large foreign
exchange (FX) rate changes. It is possible that national inflation measures will not adjust rapidly enough to
reflect the real impact of large FX changes. For example, this occurred in Indonesia in 1997, when the
Asian economic crises caused the Indonesian rupiah to drop rapidly from approximately 2400 rupiah per
US dollar to 14,000 per dollar. In comparison, the Indonesian inflation indices remained relatively stable.
Since telecommunications operators paid for equipment purchase, financing charges, etc. in foreign
currencies, the drop in the rupiah translated into a massive increase in operating costs, which was not
reflected in the national inflation indices.
To account for such large FX changes, a pre-established mechanism could provide for an adjustment to
the inflation factor – for example, if the percentage change in the average monthly exchange rate is higher
than the corresponding percentage change in the inflation factor by a specified amount (perhaps 20 to
30%) within any specified period.
By way of illustration, let us assume a 25% threshold. If the Indonesian rupiah depreciated by 35% during
the relevant period (hence, increasing by 35% the number of rupiah required to purchase a US dollar), but
the national inflation measure increased by 30%, the trigger mechanism would not apply. However, if the
inflation measure only increased by 5%, an adjustment would be triggered.

4.3.5.1 X-Factor Determination ity. The implementation of this approach is subject to

the availability of specific data. The calculation may
The X-factor may be divided into the “basic offset” be very data-intensive and requires reliable and
and adjustment factors. The basic offset should consistent data of a very specific nature at an
reflect the regulated operator’s historical achieve- adequate level of detail for an adequate period of
ment of productivity growth. If the operator has had time.
a history of lower input price inflation than other firms
in the economy, that should be reflected in the basic The other approach, which we will refer to as the
offset. Adjustment factors are included to take into regulatory benchmarking method, recognizes that in
account changes in the operating environment of the some instances, past productivity performance may
regulated operator. For example, an adjustment not be a good indicator of future expected perform-
factor might reflect the introduction of price cap ance. This may be the case where the sector was
regulation, the introduction of competition or the pri- previously regulated by discretionary price setting (or
vatization of the operator. not regulated at all). It may also be the case where
the sector has been inefficiently operated under
There are two major approaches to determination of public ownership or is subject to very significant
the X-factor. One approach, which we will refer to as structural change, for instance, divestiture. In these
the historical productivity method, relies on historic cases, the adjustment factors may be much more
information about the productivity performance of significant than the calculated basic offset. A
the regulated firm to set the basic offset. Once the benchmarked productivity factor is likely the only
basic offset is calculated, certain adjustment factors practical alternative in many developing countries.
may be added or subtracted to take into account There the regulator is not likely have access to
changes in the operating environment of the reliable and consistent historical productivity data to
operator. These adjustment factors are based on determine the historical productivity factor.
regulatory benchmarking or other predictive
methodologies. This approach is based on the
understanding that past productivity, with
adjustments, is a good indicator of future productiv-

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 Module 4 – Price Regulation

4.3.5.2 Historical Productivity Method provides an overview of TFP and how it may be
applied to the telecommunications sector.
A number of empirical methods can be used to help
the regulator set the X-factor. Most of these methods Historical Productivity - Basic Offset
were developed in the countries that first imple-
mented price cap regulation (United Kingdom, Price cap regulation is intended to replicate the
United States, Canada, etc.). The preferred method discipline of competitive market forces. These forces
to determine an X-factor is to carry out a total factor require operators to improve productivity and pass
productivity (TFP) study using historical data on the their gains on to their customers in the form of lower
regulated operator and/or on the sector. Box 4-8 prices, after accounting for increases in input prices.
If all sectors in the economy were fully competitive,

Box 4-8: Total Factor Productivity

Productivity is the measure of how effectively an entity employs inputs to produce outputs. It is a measure of
operational efficiency. A typical, although partial, measure of productivity in the telecommunications industry
is lines (one output) per employee (one input). Lines per employee is obviously only a partial measure,
given that one could increase the number of lines by increasing capital investment or materials.
Simultaneously, a telecommunications operator produces many more outputs than just the number of lines.
TFP (also known as multi-factor productivity) measures how effectively an operator, an industry or an
economy employs all inputs to produce all outputs. TFP can be said to have increased if the operator
produces more outputs with the same amount of inputs, or if it produces the same outputs with fewer inputs.
TFP is equal to the ratio of output volume to input volume. Algebraically the TFP index may be expressed
as:
TFP = Q/Z
Where Q is an index of aggregate output volume and Z is an index of aggregate input volume. Note that for

Price Regulation
price cap regulation we are primarily interested in the changes in the TFP index, rather than its level. If we
refer to changes by the symbol ∆, the change in the TFP index may be expressed in the following manner:
∆ TFP = ∆Q/∆Z
Example:
If the output volume index has increased by 5% (i.e. ∆ Q=1.05) and the input volume index has increased
by 2% (i.e. ∆ Z= 1.02), the change in the TFP index is 2.94%:
∆ TFP = 1.05/1.02 = 1.0294
Note that for the sake of simplification regulators and analysts often approximate the multiplicative
relationship between TFP, Q and Z by an additive relationship. In this instance, if output has increased by
5% and inputs by 2%, it can be said that TFP has approximately increased by 3%:

Approximation: ∆ TFP ´ ∆Q – ∆Z
´ 5% - 2%
´ 3%
It should be stressed that while this type of approximation is fairly common, it is not always accurate. While
in the example above the approximation (2.94%) was quite close to the actual number (3.00%), this will not
always be the case. Generally, the larger the change in TFP the larger the inaccuracy of the approximation.

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Telecommunications Regulation Handbook

output prices in the economy would grow at a rate industry are expected to increase 0.5% annually,
equal to the difference between the growth rate of and the corresponding growth rate of input prices
input prices and the rate of productivity growth. elsewhere in the economy is 2.5%. In this setting,
the X-factor should be set at approximately 4% (= [3
As described in Bernstein and Sappington (1998), if - 1] + [2.5 - 0.5]). Note that for simplicity we have
regulated telecommunications operators were like a approximated the X-factor by adding and subtracting
typical company, the telecommunications regulator the different variables. As pointed out in Box 4-8, for
could replicate market discipline by restricting in- small numbers this is generally a fair approximation
creases in the operator’s prices to the economy- to the mathematically-correct multiplicative
wide rate of price inflation. This restriction would calculation.
require the regulated operator to achieve the same
productivity gains as that of the typical company, Table 4-2 presents the results of some studies of
and to pass these gains on to its customers, after TFP for the US communications industry and
adjusting for the typical input price inflation rate. If corresponding TFP performance of the US economy
the regulated operator faces the same input price as a whole. Based on Table 4-2 and other studies
inflation rate as other companies in the economy, (including those of the Canadian telecommunica-
the X-factor should be set at zero. tions industry), it appears that in the long-term
productivity growth of the communications industry
Generally, therefore, the X-factor should reflect the in North America has been about 2% to 2.5% higher
extent to which: than productivity growth of the respective
economies. Some of these studies are dated and
➢ the regulated operator is capable of increasing the productivity differential may have changed
its productivity more rapidly than other recently.
companies in the economy; and
The choice of the inflation factor will have an impact
➢ the prices of inputs used by the regulated on the choice of variables to calculate the basic
operator grow more slowly than the input prices offset. If a general inflation index is selected for the I-
faced by other companies in the economy (this factor (e.g. GDP-PI or CPI or RPI, etc.), the basic
is often referred to as the input price differential productivity offset should be calculated as in the
or IPD). example presented two paragraphs above. This is
referred to as the differential approach. Based on
Telecommunications operators should normally this approach, the figures in Table 4-2 suggest a
enjoy faster productivity growth than other basic offset between 2.0% and 2.5%. If a sector or
companies due to the more rapid rate of operator-specific index is constructed, however, the
technological change in the telecommunications appropriate basic offset is simply the
industry. Telecommunications operators may also telecommunications TFP estimate. This is referred
have lower input price inflation due to the decreasing to as the direct approach. Based on his approach,
unit costs of processing, switching and transmission. the figures in Table 4-2 suggest a basic offset
between 3.0% and 3.5%.
If the regulated operator can achieve faster produc-
tivity growth or enjoy lower input price inflation than Historical Productivity Adjustments
other companies in the economy, then the regulated
operator should be required to pass the associated Many regulators have adjusted the basic offset by
benefits on to customers in the form of lower prices. other factors to take into account significant changes
in the operating environment of the regulated
For example, assume the expected annual rate of operator. We review some of the key adjustment
productivity growth of the regulated operator is 3%. factors below. These adjustment factors are often
The corresponding growth rate elsewhere in the determined based on benchmarking or predictive
economy is 1%. Input prices in the regulated methods, such as time-series, cross-sectional
econometric studies.

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 Module 4 – Price Regulation

Table 4-2: Selected Estimates of TFP for the US.

Study Period COM US DIFF

Nadiri- 1947-76 4.1 2.0 2.1
Schankerman
Jorgenson 1948-79 2.9 0.8 2.1
Christensen 1947-79 3.2 1.9 1.4
AT&T 1948-79 3.8 1.8 2.0
A.P.C. 1948-87 4.0 1.7 2.3
Christensen 1951-87 3.2 1.2 1.9
Crandall 1960-87 3.4 1.3 2.1
DRI 1963-91 3.0 0.2 2.8
Christensen 1984-93 2.4 0.3 2.1
Note: US Communications Industry (COM); US Economy and Differential (DIFF %)
Source: Taylor (1997)

Incentive Regulation Factor Competition Adjustment

After price cap regulation replaces ROR regulation The rise of strong competition is another structural
or, more likely, when it becomes the first form of change that can affect the value of the X-factor

Price Regulation
rules-based price regulation adopted, operators in under price cap regulation. The effect of increased
the industry can be expected to achieve a higher competition, however, is unclear.
productivity growth rate than they have in the past.
On the one hand, increased competition, like a
In such circumstances, some regulators have sup- change in regulatory regime, can force the regulated
plemented the basic offset with what is sometimes operator to operate more efficiently, and thereby
called a customer productivity dividend (CPD). A achieve a higher productivity growth rate. This would
number of econometric studies have examined the seem to favour a higher X-factor, particularly if a
impact of incentive regulation plans on productivity CPD has not been imposed.
of telecommunications operators. On the whole,
these studies have concluded that incentive regula- On the other hand, increased competitive forces can
tion has a positive impact on productivity growth. shift market share from incumbent operators to new
entrants. The result can be an unavoidable reduction
In principle, the CPD should reflect the best estimate in the growth rate of the incumbent’s outputs. Par-
of the increase in the productivity growth rate in the ticularly in the short run, this lowering of the growth
regulated sector that will be brought about by the rate of the incumbent’s outputs can be higher than
improved incentives inherent in the new regulatory any associated lowering of the growth rate of its
regime. This variable, also referred to as the stretch inputs. This leads to a lower productivity growth rate
factor, could be allowed to vary over the life of the for the incumbent, arguing for a lower X-factor. The
price cap plan. For example, the variable may be empirical evidence on the effect of competition on
higher at the beginning of the plan and reduced near productivity growth is mixed. A number of recent
its end. CPDs adopted in the US and Canada have time-series, cross-sectional econometric studies
generally been below 1% per year. have found no relationship between competition and

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Telecommunications Regulation Handbook

productivity growth, after taking into account other that the X-factor should be set at relatively high
factors. levels. On the other hand, there are some very
efficient telecommunications sectors in the
Privatization Factor developing world that may not be subject to
such “catch-up” phenomenon.
The theoretical literature suggests that privatization
should increase productivity growth. The theory is Countries that have had a number of price cap plans
substantiated by recent econometric studies that have generally increased the X-factor over time.
have found privatization to increase productivity by One example is that of British Telecom (BT) in the
at least 0.5% to 1.0% per year. United Kingdom (UK), where the X-factor has been
increased from 3% in the 1984-1989 period to much
4.3.5.3 Regulatory Benchmarking Method higher factors in recent years (see Table 4-3). This
regulatory “tightening” has been a result of better-
In some instances, past productivity performance than-expected performance by the regulated
may not be a good indicator of future expected operator. The major increases in the X-factor from a
performance. This may be the case where the modest initial figure also reflects a degree of
sector was not price regulated, was not operated regulatory caution, with an initial bias towards
efficiently or is the subject to very significant struc- ensuring the regulated operator's revenue
tural change. requirement is met.

In these circumstances, or when the operator and/or No price cap plan, no matter how carefully designed,
its operating environment are undergoing drastic will be perfect or permanent. It is in the nature of
change, the X-factor may have to be developed good regulation to evolve with market and policy
based on the informed judgement of the regulator developments. The evolving nature of price cap
and its advisors. International experience with price regulation is perhaps best illustrated by the changes
cap regulation can provide a useful benchmark in in the various price cap plans that have been applied
such cases. This is why we refer to this method as to British Telecom. BT was the first telecommunica-
regulatory benchmarking. tions operator subject to price cap regulation. It
remains subject to this form of regulation, but as
Furthermore, this approach may be the only practi- illustrated in Table 4-3, there have been significant
cal alternative in many developing countries changes over the years. Regulators that are
because of lack of the very specific detailed considering introducing price cap regulation should
historical data over an adequate period of time to take comfort from the British experience. The most
calculate TFP. More generally, the historical method significant decision at the time of the privatization of
may be less applicable to developing economies for BT was to adopt price cap regulation – not to specify
the following reasons: its particular X-factor, and other details. The actual
form of regulation was not cast in stone. As in other
➢ Low teledensity levels, and privatization of countries where price cap regulation has since been
former government telecommunications opera- adopted, adjustments continue to be made as the
tors, can be expected to lead to significant regulator’s experience with this form of regulation
productivity improvements; increases, particularly with respect to the determina-
tion of the X-factor.
➢ Significant political and economic instability, and
the lack of a clear legal and regulatory Table 4-4 and Table 4-5 provide examples of current
framework may affect productivity levels, and; X-factors adopted by regulators around the world.
Although there is some variation in the actual X-
➢ Recent evidence suggests that technological factors set by regulators, based on this selected
catch-up and the possibilities for greater sector sample, when a majority of the operator’s services
growth in developing countries mean that are included in price cap regulation, many regulators
productivity growth should be higher than in have selected an X-factor in the range of 3.5% to
industrialized economies. This would suggest 4.5% as the initial X-factor. This range is generally

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 Module 4 – Price Regulation

Table 4-3: A Summary of British Telecom' s Price Cap Plans

Duration X Services Subject to Price Other Main Pricing Main Services Not
Caps Constraints Subject to Price Caps
1984-89 3.0 Subscription; local and Residential subscription Rental, international calls,
national calling (RPI+2) operator services , con-
nection charges, public
telephone calls
1989-91 4.5 Subscription; local and Subscription (RPI+2); Rental; international calls
national calling connections (RPI+2); and public phone calls.
private circuits (RPI+0).
1991-93 6.25 Subscription; local and Residential and single line Telephone rental; public
national call charges; subscription (RPI+2): telephone calling.
international calls; volume multi-line subs. (RPI+5);
discounts. connection (RPI+2);
private circuits (RPI);
median res.bill (RPI)
1993-97 7.5 Subscription; local and All subscriptions (RPI+2); Public telephone calling.
national calling; interna- all individual prices in
tional calls; connection basket limited to RPI
charges. including connection
charges; private circuit
basket (RPI).
1998-2001 4.5 Retail charges: residential Business assurance Public telephone calling.
connection subscription; package, including
local, national and inter- subscription (RPI),

Price Regulation
national calls. Based on analogue private circuits
expenditure patterns of (RPI).
lowest spending 80% of
residential customers.

8.0 Network charges: non- Services divided into three

competitive access baskets, each basket
services (call origination subject to RPI-8 cap.
and termination, single
transit, local conveyance)
and interconnection
specific service.

Source: Adapted from OECD (1995) and Oftel (2000a)

consistent with the differential approach to calculat- discussed below may assist in regulatory
ing the X-factor. The more detailed guidelines judgements to set the X-factor.

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Telecommunications Regulation Handbook

Table 4-4: X-Factors of Selected National Table 4-5: X-Factors of Selected State Price
Price Cap Regulation Plans Cap Regulation Plans in US

Country X-Factor State X-Factor

Argentina 5.5 Connecticut 5.0
Australia 7.5 Delaware 3.0
Canada 4.5 Georgia 3.0
Chile 1.1 Illinois 4.3
Colombia 2.0 Maine 4.5
Denmark 4.0 Massachusetts 4.1
France 4.5 Michigan 1.0
Ireland 6.0 New York 4.0
Mexico 3.0 North Carolina 2.0
Portugal 4.0 Ohio 3.0
UK 4.5 Rhode Island 4.0
US 6.5 Wisconsin 3.0

Regulatory Benchmarking ➢ Direct Approach

➢ Differential Approach The long-term historical productivity performance

of the telecommunications sector is generally
The long-term historical productivity differential accepted to be 3% to 3.5% or higher. We
between the telecommunications sector and the discussed this range in the previous section. This
economy is generally accepted to be 2% to 2.5% benchmark could be higher where productivity in
or higher. We discussed this range in the the telecommunications sector is expected to
previous section. This benchmark can be higher grow at a rate significantly higher than that of the
where the telecommunications sector is economy.
expected to grow at a rate significantly higher
than that of the economy. Regulatory Benchmarking – Adjustments

The long-term historical input price differential Adjustments can be made for the effects of the
(IPD) between the telecommunications sector introduction of incentive price regulation, competi-
and the economy is generally accepted to be tion, and privatization, where these conditions apply.
positive, but smaller than 1%. The IPD could be These factors and their effects are discussed above.
lowered if, for example, a telecommunications Table 4-6 provides a numerical summary of the
worker’s wages grew faster than that of the benchmark estimates discussed in this Section.
average worker. Conversely, the IPD should be These are of a general nature. It is recommended
raised if the rate of productivity-improving tech- that each country carry out an appropriate TFP or
nological development in the telecommunications benchmarking study based on specific national
industry increases. conditions.

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 Module 4 – Price Regulation

Table 4-6: Summary of Benchmark Estimates for Setting X-Factor (%)

Differential Approach Direct Approach

Basic Offset 2.0 to 2.5 3.0 to 3.5

Adjustment Factors
Incentive Regulation 0.5 to 1.0
Competition 0.0*
Privatization 0.5 to 1.0
Note: * Could be increased to up to 0.5 if competition is combined with privatization.
Source: Based on McCarthy Tétrault review of the literature and experience with price cap regulation in
industrialized countries. Estimates may be less applicable to developing countries. These estimates are of a
general nature. It is recommended that each country carry out an appropriate TFP or benchmarking study
based on specific national conditions.

4.3.6 Capped and Non-Capped Services ultimately reflected in retail prices. Access services
can also be placed in a separate basket from retail
A basic decisions to be taken in price cap regulation services to prevent the dominant supplier from “price
is the selection of which services to regulate. In squeezing” its competitors through its control of both
general, regulators apply price cap regulation to retail and wholesale pricing.
services that are provided on a monopoly or domi-

Price Regulation
nant provider basis. The rationale for price regulation 4.3.7 Service Baskets
is discussed in Appendix B of the Handbook.
Having selected the services to be included in price
In many markets, the distinction is made between cap regulation, the structure of the price cap plan
“basic services” which are price-capped, and other should be determined. One of the features of price
services which are not. Services provided in fully cap regulation is that the regulated operator
competitive markets are normally excluded from maintains some pricing flexibility. This flexibility is
price cap plans. There is sometimes a grey line particularly important when significant rate rebal-
between the categories, and regulators have treated ancing is required within the price cap plan. It is also
the same types of services differently. Table 4-7 and important when the operator is facing competition
Table 4-8 describe the types of services covered by and must respond quickly to competitive price
price cap plans in the same jurisdictions as in Table challenges. Nevertheless, there are a number of
4-4 and Table 4-5 around the world. reasons for the regulator to restrict pricing flexibility.

Services are sometimes included in price cap One reason is to restrict the operator’s ability to
baskets to promote competition and to protect con- engage in inappropriate cross-subsidization. Such a
sumers. An example is the case of interconnection restriction can be implemented through the creation
charges. Interconnection access charges can be of groups of services, or service baskets, within the
included under a global price cap that could price cap plan. An example of how service baskets
incorporate consumer “retail” and access constrain flexibility is provided in Box 4-9.
“wholesale” services. This would make it possible for
expected productivity gains in the provision of ac- It is common practice to place capped services in
cess services to be passed on to competitors and be more than one basket. For example, Figure 4-3 and

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Telecommunications Regulation Handbook

Table 4-7: Service Coverage of Selected Table 4-8: Service Coverage of Selected
National Price Cap Regulation Plans Price Cap Regulation Schemes in US

Country Service Coverage State Service Coverage

Argentina Basic services Connecticut Basic and non-competitive
services
Australia Basic and mobile services Delaware Basic services
Canada Basic local services Georgia Basic and other services
Chile Local and access services Illinois Non-competitive services*
Colombia Local services Maine All services
Denmark Basic and ISDN services Massachusetts Non-competitive services*
France Basic services Michigan Non-competitive services
Ireland Basic and ISDN Services New York Basic services
Mexico Basic services North Carolina Basic services
Portugal Basic and leased line services Ohio Basic Services*
UK Basic residential services Rhode Island Basic services
US Interstate access services Wisconsin Basic and other services
Note: * excludes basic residential services

Figure 4-4 illustrate the service baskets for the ➢ degree of substitutability of each service.
Telecom Australia price cap plan. Different types of
services are grouped in different baskets, and serv- 4.3.8 Individual Service Pricing Restrictions
ices with common characteristics are grouped within
a single basket. Restrictions can be placed on the relative and/or
absolute movement of prices of individual services,
Many regulators have established different “sub- as well as on service baskets. This may be done, for
caps” on different baskets. In effect, these basket- example, if the regulator is concerned that the resi-
pricing restrictions are used by regulators to further dential subscription rate may rise too quickly as a
constrain the pricing flexibility of the operator. For result of rate rebalancing.
instance, in Figure 4-4, subscription services would
be subject to the CPI-2% sub-cap of its service The maximum allowable price increase for individual
basket and also to the overall price cap of CPI-5.5%. services will be inversely proportional to the weight
of the individual service within the services basket.
The assignment to baskets is intended to replicate As a result, the price for services with relatively small
the effects of competition. The following are general weights could increase significantly if the allowed
criteria for assigning capped services into service increase were channelled towards one of these
baskets: services and there were smaller compensating
decreases in charges for services with relatively
➢ degree of competition in each service basket; larger weights. Conversely, a service with a
relatively heavy weight within the proposed services
➢ homogeneity of services (including similarity in basket would be subject to only moderate price
demand price elasticities); and increases if the allowed increase were channelled to

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 Module 4 – Price Regulation

this service, even though compensating decreases provide sufficient flexibility to permit necessary rate
were made in services with relatively smaller rebalancing, while protecting consumers from
weights. excessive rate increases and competitors from anti-
competitive subsidization. Too many restrictions on
There are two alternatives to individual restrictions, prices will eliminate pricing flexibility, one of the main
each of which may be applied to restrict the benefits of price cap regulations.
decreases and/or increases in prices.
4.3.9 Duration and Review of Price Cap
One of these methods, commonly referred to as Plans
“banding”, limits the price movement of specific
services relative to another variable, usually the The longer the term of a price cap plan, the stronger
inflation factor. For instance, if the regulator is the incentive for the operator to improve its
concerned about increases in the residential performance. In theory, the duration of a price cap
subscription price, an upper restriction could provide plan should be indefinite, so that the regulator would
that the price could not increase at a rate greater not intervene in the setting of future prices.
than the inflation factor plus 5% (CPI + 5). If the X-
factor has been set at 4% and the corresponding I- In practice, however, this type of price cap regime is
factor was 7%, the weighted average of prices could neither feasible nor desirable. A regulator cannot
increase by approximately 3% (7% - 4%). The estimate future productivity growth with certainty; nor
residential subscription price, however, could can it set the X-factor at the right level for an
increase up to a maximum of approximately 12% indefinite period. With the X-factor set imperfectly,
(7% + 5%). This is an example of a relative restric-
tion. In the case of Telecom Australia provided in
Figure 4-3, the residential subscription and local Box 4-9: How Service Baskets Constrain
calls are subject to an individual restriction of CPI. Price Flexibility - Example

The other type of restriction is absolute. For Assume a one-basket price cap plan. It
example, if the regulator is concerned that national includes international services and residential

Price Regulation
long-distance rates may decline too quickly, a subscription services. Assume both have the
downwards restriction could provide that the aver- same weight in the price cap index. Holding
age price of these calls should not decrease by all other prices constant, a decrease in
more than 20% per year. domestic long distance prices (say 30%) can
be offset by a significant increase (also 30%,
It is generally considered that relative restrictions are assuming the same revenue weights) in the
residential subscription rates.
preferable to absolute ones because they provide
the regulator with greater certainty as to the To constrain this type of offsetting rate
movement of the real (inflation-adjusted) prices of rebalancing, residential subscription services
the services. and international services can be placed in
separate baskets. If this were done, price
decreases in one service cannot be offset by
Restrictions may be upwards or downwards, but do equivalent increases in the price of other
not necessarily have to be symmetrical. For services.
example, if access prices are included in the price
cap, they could be subject to relative restrictions with In practice, of course, regulators should not
upward and downward bounds (e.g. inflation factor constrain operators from implementing
necessary rate rebalancing. Individual price
±5%). constraints or bands can be used to limit
price increases to particularly sensitive
Restrictions on the regulated operator’s pricing flexi- services, with less impact on the overall
bility have been implemented by most regulators. pricing flexibility of operators.
Care must be taken to design restrictions that are
internally consistent and do not unduly constrain the
operator. Judgment is required to set restrictions that

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Telecommunications Regulation Handbook

Figure 4-3: Price Cap Plan for Telecom Australia Figure 4-4: Price Cap Plan for Telecom
from 1989 to 1992 Australia from 1992 to 1995

Overall Price Cap: CPI-5.5 %

Domestic Cap: International Cap:
CPI-4 % CPI-4 %

• Subscription • International Calls Sub Cap:

• Local Calls Sub Cap: CPI-2 %
• Domestic LD Calls CPI-5.5 % Sub Cap:
CPI-5.5 %
• Connections
• Domestic LDCalls • Subscription
• Local calls • International Calls

Individual Restrictions:
CPI

Individual Restrictions: CPI Charges Subject to

• Subscription (in any one year) Overall Cap Only
• Residential
• Local Calls • Domestic Dedicated
• Connections
• Rentals Lines
• Local Calls • International Dedicated
• Trunk Calls Lines
• Mobile Telephone
Service

the operator would either earn insufficient revenues The price cap plan review process should be
or unacceptably high profits. Both outcomes are carefully designed. The key variable that will have to
inefficient and unsustainable. As a result, in a real- be reviewed, and perhaps reset, is the X-factor. This
world price cap plan, the regulator generally sets a will be a primary focus of the review. It involves
minimum period during which the X-factor will not be some complex incentive issues for the regulator to
revised. At the end of the duration period, a review is grapple with.
undertaken. Regulators have typically chosen
periods of three to five years. If productivity improvements achieved by the
operator exceed the X-factor by a substantial
The duration of the plan should be sufficiently long to amount, the operator will make significant profits.
allow efficiency incentives to be acted on. However, There may be pressure on the regulator to adjust the
it should not be so long that market developments value of the X-factor upwards. Rate of return or
undermine the regime. In the Regulatory Bench- other profit indicators are generally used to reset the
marking Section, above, it was suggested that a X-factor. This review mechanism will reduce the
prudent approach would be to set an initial X-factor regulated operator’s incentive to continue to
conservatively. In such as case, the plan should be increase its productivity. The incentives for further
reviewed reasonably soon, to minimize the negative efficiency improvements will tend to fall as the
impact of miscalculations or errors of judgement in review approaches, particularly if the operator knows
setting the X-factor. that any additional cost savings will result in a higher
X-factor resulting from the review process. In this

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 Module 4 – Price Regulation

instance, price cap regulation will approximate ROR

regulation during the review period. The optimal Box 4-10: Examples of Unexpected Input
selection of incentives/disincentives will ultimately be Price Change Outside Control of
based on regulatory judgement. Regulated Operator

The approach to resetting the X-factor will depend An increase in customs duty from 20% to
on how the regulator evaluates the need for the op- 40% is imposed on imported capital
erator to earn higher profits to increase its ability to equipment, including telecommunications
attract investment, compared to the consumer equipment. The telecommunications operator
benefits of lower prices (operator-consumer equity faces a significant input price increase.
objective). It will also depend on the relative Assuming new equipment purchases account
for 20% of the annual costs of the operator,
importance placed on productive and dynamic
the customs increase could increase total
efficiency. The higher the weight placed on costs by 4%. This change may not be fully
consumer benefits relative to profits in the short reflected in the inflation factor. Assuming that
term, the more the regulator will tend to reduce new foreign equipment purchases account for
future profits by setting a higher X-factor at the time 5% of economy-wide costs, an economy-wide
of the review. inflation index would increase by only 1%. As
a result, the operator would have to absorb
the remaining 3% increase in its costs.
4.4 Price Cap Variations

4.4.1 Introduction

This Section considers some of the variations that inflation factor. Most developing country price cap
have been applied to the basic price cap formula. plans do not include a Z-factor. However, the situa-
Depending on national telecommunications market tion may be quite different in emerging markets
conditions, regulators may include some of these where significant exogenous events are more
variations in their price cap plan. common.

Price Regulation
4.4.2 The Exogenous Factor If the regulator decides to include a Z-factor adjust-
ment, the amended price cap formula would be as
As discussed above, the inflation factor is a proxy for follows:
the changes in the regulated operator’s input prices.
There may be instances, however, when the t t-1 t
PCI = PCI x (1 + I – X ± Z )
t

operator faces a significant change in input prices

that are outside its control and not captured by the It should be recognized that the practical application
inflation factor. An example is provided in Box 4-10. of a Z-factor adjustment could be administratively
Regulators must decide whether to include in the challenging and a source of controversy. Some of
price cap formula a cost pass-through variable (also the uncertainty can be eliminated by carefully
referred to as an “exogenous” variable or “Z-factor”) defining the types of cost changes covered by the Z-
to address this possibility. factor.
The inclusion of a Z-Factor in a price cap formula is Based on the considerations outlined in Box 4-11,
not always warranted. Many US state regulators the regulator should define the exogenous factor to
have not included a Z-factor in their price cap plans. promote certainty in price regulation of the sector. In
They may consider that there are very few truly preparing this definition, the criteria should be
exogenous events that are not captured in the general enough to capture the impact of certain
events without diminishing the operator’s incentive
to control its costs.

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Telecommunications Regulation Handbook

Box 4-11: What are Exogenous Cost Changes?

The following considerations are relevant in determining which cost increases may be covered by a Z-
factor:
➢ Generally, legislative, judicial or administrative actions that have a significant impact on the regu-
lated operator should be considered. Such actions are usually beyond the control of the
operator. With respect to “significant”, there may be an advantage to setting a threshold below
which adjustments would not be considered. A threshold in the range of 1% to 2% of revenues
may be reasonable.
➢ Regulators should only consider events that do not represent normal business risk. In assessing
whether costs should be included in a Z-factor, the regulator should consider whether the
operator can take reasonable measures to mitigate the consequences of the cost-producing
events.
➢ The Z-factor costs should not otherwise be reflected in the price cap formula and must be such
that they have specific or disproportionate impact on the operator. The burden of proof should be
on the operator to show that the proposed event is not already accounted for in the inflation
factor and would be reflected in prices charged by operators operating in competitive markets.
➢ Events, such as an economic downturn, that affect the whole economy would generally not be
considered to produce exogenous cost increases eligible for Z-factor treatment. While such
events may have a negative impact on the demand for the operator’s services, and decrease its
ability to recover costs, the purpose of the Z-factor is not to guarantee a rate of return for the
operator. Such a guarantee would not be consistent with the objective of using price cap
regulation as a proxy for competitive market conditions.
➢ Z-factor costs should be quantifiable and known. The operator must be able to estimate the spe-
cific costs in monetary terms.

In theory, the impact of the exogenous event should operator to request the consideration of an event
be allocated across capped and uncapped services, that has increased its costs. Where an event has
with only the impact allocated to capped services decreased the operator’s costs, however, the
being included in the price cap formula. In practice, operator has no incentive to request consideration. If
the regulator could use revenue shares or other a Z-factor exists, the regulator will likely have to
weights to allocate the impact to capped services ensure that savings are passed on to consumers.
only.
4.4.3 Quality of Service
Generally, the regulator will design the exogenous
factor so that the regulated operator must request Like other services, telecommunications services
the inclusion of exogenous cost changes in the price have a quality component and a price component. In
cap formula. The onus is placed on the operator to theory, a telecommunications operator subject to
take action in the matter. The regulator only has to price cap regulation could increase profit by lowering
decide on the issue if and when there is an applica- the quality of its service. This prospect is of most
tion before it. concern when the operator is a monopolist, or is
dominant so that it’s service levels are not subject to
An exogenous event may increase or decrease the effective competitive pressure from other operators.
costs of the operator. It will be in the interest of the

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 Module 4 – Price Regulation

Table 4-9: Q-Factor Example –Rhode Island Scheme

The price regulation plan for the incumbent operator in Rhode Island, NYNEX, includes a Service Quality
Adjustment Factor "SQAF". It was added to the basic price cap formula in the following manner
t t-1 t t
PCI = PCI x (1 + I – X ? SQAF )
Each month, NYNEX provides reports to the regulator on QoS performance. As illustrated in the table
below, the maximum value for the Service Quality Index (SQI) is 42. The regulator has determined that a
passing monthly score is 25. The price cap formula is adjusted once a year. At that time, for each of the 12
most recently measured months that NYNEX has not achieved a passing score in the SQI, the SQAF will
be increased by .0417%. Hence, if NYNEX does not receive a passing score in 6 months, the SQAF will
take the value of 0.25%, and prices must be decreased by that amount in the next period to compensate
for poor QoS performance.

Nynex Performance Points

New Installations orders not completed <12 2
within 5 working days (%) 12.0-13.99 1
A14.0 0
Installation appointments missed (%) < 2.5 2
2.5 – 3.49 1
A3.5 0
Line out of service > 24 hours (%) < 40 4
40 – 44.99 2
A45 0
Repeat repair reports (%) < 11 2

Price Regulation
11.0 – 13.99 1
A14 0
Repair service answer time (sec.) < 14.0 4
14.0 – 16.99 2
A17 0
Directory assistance answer time (sec.) < 4.0 2
4.0 – 5.99 1
A6.0 0
Average duration time – special access < 2.5 2
1.5 Mbps Circuits (hours) 2.5 – 4.49 1
A4.49 0
Sub-total (maximum available) 22

Customer trouble reports per 100 lines < 4.0 2

per central office (CO) 4.0 – 4.99 1
A5 0
Sub-total (maximum available assuming 20
10 CO’s reviewed)
TOTAL POSSIBLE POINTS/MONTH 42

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Telecommunications Regulation Handbook

Telecommunications Quality of Service (QoS) has minimum quality standards similar to minimum price
many aspects. It has traditionally been measured by floors. It should be recognized that the incorporation
a number of QoS indicators, such as: of a Q-factor can be complex and administratively
challenging. Few regulators have integrated QoS
➢ Call Completion Rate and price cap regulation in this manner.

➢ Dial Tone Delay 4.4.4 New Services

➢ Delivery Precision A key objective of telecommunications sector reform

is to promote innovation, particularly in the introduc-
➢ Call Failure Rate tion of new services. The regulator must determine
whether or not to subject new services to price
➢ Fault Clearance regulation. If the decision is affirmative, price cap
regulation is sufficiently flexible to accommodate
➢ Complaints most new services.

➢ Billing Accuracy. In markets that are subject to competition, many

regulators have concluded that it is not in the public
If a regulator decides to regulate QoS of an operator interest to regulate most new services. Such
subject to price cap regulation, it can adopt several decisions provide an additional incentive for opera-
approaches. The traditional approach is to set a se- tors to introduce innovative services; mobile services
ries of QoS targets or standards for each indicator. are a common example.
Sub-standard performance can be dealt with on a
case-by-case basis, or by pre-set sanctions (e.g. Where such a decision is taken, it is important for
monetary fines or penalties payable by the the regulator to ensure that a regulated operator’s
operator). “new” service is truly new. Operators will have an
incentive to try to repackage existing services as
An innovative approach is to integrate a QoS “new” services in order to avoid price regulation. To
variable, often referred to as a Q-factor, in the price avoid confusion in the industry, the regulator may
cap formula. This is a relatively new approach. It is want to consider publishing a definition of a new
being implemented in a few states of the US. Table service based on the criteria, such as the following:
4-9 provides a summary of such an approach in the
US State of Rhode Island. A similar approach has ➢ Does the new service include a new technology
also been recently adopted in Colombia at the or functional capability?
national level. This approach is consistent with the
objectives of incentive regulation. In addition, it has ➢ Does the new service replace an existing
the advantage of directly linking QoS with the price service and consequently not expand the range
mechanism, thus mimicking the quality/price trade- of services available?
off in competitive markets. The following formula
illustrates how a Q-factor fits into the basic price cap 4.4.5 Rate Rebalancing and Price Caps
formula:
Rate or price rebalancing is discussed in Section
t t-1 t t
PCI = PCI x (1 + I – X
Q ) 4.1.2 and in Appendix 4.2. It refers to the adjustment
of price levels for different services to more closely
The objective of including a Q-factor is that a reduc- reflect the costs of providing each service. Rebal-
tion in quality should result in lower prices for ancing can be achieved under most forms of price
consumers. Conversely, increased quality may lead regulation.
to higher prices. If there is concern that quality may
drop to unacceptable levels, the regulator may set

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 Module 4 – Price Regulation

A regulator that implements a price cap plan should 4.4.6 International Accounting Rates
consider including a transitional period for rate
rebalancing, either before the plan comes into effect Technological developments and the liberalization of
or as part of the plan. The transition period should telecommunications markets have put downward
be kept as short as possible and, depending on the pressure on international accounting rates.
level of price-cost imbalances, should not last more Accounting rates are the charges payable to inter-
than 5 to 7 years. This will ensure that prices at the connecting international operators under traditional
beginning of a price cap plan are more in line with settlement arrangements for mutual termination of
costs than they would be without a transition period. traffic between their networks. In most countries,
In a number of countries, regulators have allowed during the last few decades of the 20th Century, the
the regulated operators a period of several years to level of accounting rates was well above the cost of
providing international service termination.
achieve limited rebalancing. This decision is based
on the conviction that the benefits of price cap Profits from high accounting rates provided a signifi-
regulation are greater when prices are balanced. cant source of cross-subsidies, particularly to
Rebalanced prices are clearly closer to those found developing countries. It also led to a major
in a competitive market. imbalance in payment of accounting rates from
countries that originated more calls than they
A new regulator will likely be confronted with the terminated. There has been strong pressure from
necessity to rebalance prices and to introduce a the US and other countries with outbound account-
form of price regulation for the first time. Given the ing rate imbalances to reduce accounting rates. This
benefits of rebalancing and price cap regulation, pressure, the ITU response, international service
neither should be delayed. Hence, there may be no competition and technological developments have
opportunity to attain any significant rebalancing prior all led to significant decreases in accounting rates.
to the implementation of price cap regulation. It will
have to be done as part of a price cap plan. The One recent technological development that under-
regulator may prescribe the specific targets or target mines the accounting rate regime is Internet
ranges for some or all prices for regulated services. telephony, also referred to as “Voice over the

Price Regulation
Some regulators have only specified end-of-period Internet”, or “voice over IP” (VoIP) technology.
targets while others have also specified intermediate Internet telephony generally bypasses the account-
targets. In this manner the regulator may be sure ing rate regime, and hence allows VoIP providers to
that over the transition period the operator will move price their services below those of operators of
prices in the desired direction. If this is done, the conventional PSTN networks.
operator should be given sufficient pricing flexibility
to achieve rebalancing. The downward trend in international accounting
rates can be seen as an international form of rate
Establishing a transition period for rebalancing rebalancing - between international and national
before a price cap plan is implemented is only a service. Operators in a large number of countries will
practical option when there is another form of price need to increase revenues from national services to
regulation in place. In Canada, the incumbent offset potential losses from international settlements.
operators were subject to ROR regulation during the
transition period. Clearly, where the operator is a The demand for international calling is generally
privately-owned monopoly or dominant operator, considered to be price elastic, especially at higher
some form of price regulation is preferable to none prices. Reductions in international rates will there-
at all. In countries where price cap regulation is the fore usually lead to increases in international calling.
first form of price regulation to be introduced, the Local access and calling, on the other hand, are
more desirable option will be to undertake rate generally less price elastic. The result of this
rebalancing within a price regulation regime. rebalancing could therefore be higher overall
revenues for operators providing both services.

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Telecommunications Regulation Handbook

The need to rebalance international and national implement rebalancing. The potential volatility of
rates has important implications for price cap regula- international prices and uncertainty of customer
tion. For many countries, a significant amount of rate response, may make it beneficial for the regulator to
rebalancing may be both desirable and necessary. implement a fixed-weights scheme for the price cap
Accordingly, pricing restrictions should not deprive formula, at least until the majority of the rebalancing
the operator of sufficient pricing flexibility to has occurred.

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 Module 4 – Price Regulation

Appendix 4-1: OECD Rate Rebalancing

This appendix provides an overview of the OECD greater than a local call at 3 km. In 1998, the margin
tariff comparison methodology and recent analysis was reduced to about seven times.
of rate rebalancing trends in the OECD member
countries. There are a number of reasons for postalized rates.
Incumbent operators typically tend to reduce the
Figure 4-5 and Figure 4-6 show the most recent number of long-distance bands in response to com-
Business and Residential Tariff basket comparisons petitive entry. Another reason is the prevalence of
for OECD member countries. Note that these discount plans that require consumers to sign up to
baskets are based on standard listed prices rather a specific operator, often having to pay a fee. In
than the myriad of discount schemes generally return, loyal consumers receive significant savings
available in competitive markets. over standard listed prices. Figure 4-1 in the main
text of this Module indicates that rate rebalancing is
In its 1999 publication, Communications Outlook, the also evident in the price trends of calls at different
OECD noted significant rate rebalancing in its 29 distances.
member countries. For instance, it noted a major
trend towards postalized rates at the national level. Rebalancing has been slower for the residential
Postalization is the term given for the trend towards basket, as shown in Figure 4-8, than the business
flat rates for long distance services regardless of the basket, which is illustrated in Figure 4-2 in the main
distance. In other words, long distance service is text of this Module. When rate rebalancing occurred
heading for a world where, like postal services, it is in 1994, however, significant cost savings for both
usually priced the same irrespective of distance. residential and business consumers were realized.
This has been referred to in the industry as “the Fixed charges are now slightly lower than in 1990.
death of distance.” Combined with usage charge reductions in the order
of 25%, the overall price of the basket has been

Price Regulation
For instance, Figure 4-7 shows the difference reduced by nearly 15%. Note that overall teledensity
between the cost of long distance calls and a local in the OECD countries has increased steadily,
call (3 km) between 1990 and 1998. In 1990, the despite rebalancing.
average price of a call at 490 km was 20 times

Box 4-12: OECD Tariff Comparison Methodology

In 1990, the OECD established a harmonized methodology that enables international comparisons of
national telecommunications prices, using a basket of the different elements for a particular service. This
comparison can be made across countries and across time.
In recognition of the calling patterns and different prices faced by residential and business consumers, the
OECD constructed a Residential basket and a Business basket. Each basket is made up of two elements,
a fixed charge and a usage charge. The fixed charge covers a one year’s subscription with the installation
charge discounted over 5 years.
Once the fixed charge is calculated, the usage charge is based on OECD averages for the overall
allocation of fixed charges to usage charges. Based on telephone usage patterns, the usage charge can
be allocated to national calls. These calls are then priced out for each of the countries to arrive at the
monetary amount, which is either expressed in US dollars at prevailing exchange rates or based on
purchasing power parity (PPP).

4 - 35
4 - 36
Lu

0
100
200
300
400
500
600
700
800
900
Ice xe
m

500
1000
1500
2000
2500

0
lan bo
d
De urg
Lu Kor nm
xe ea
m a
bo Sw rk
u

Source: OECD(1999)
ed

Source: OECD(1999)
Sw rg en
ed No
De en rw
nm ay
ar Ko
re
No k a
rw Fi
ay Ne nlan
Tu th
rk er d

Note: Calculated Basedon PPPs, expressedin USD

Note: Calculated based on PPPs, expressed in USD
ey lan
C d
Un ana Ca s
ite da na
d da
St Un Ja
at ite pa
es
Un Ja d n
Ki
ite pa ng
d n d
Ki Be on
Ne ngd lgi
th on um
er
lan Tu
d rk
e
Fi s
Figure 4-5: OECD Business Tariff Basket

nla Ire y
Sw land

Figure 4-6: OECD Residential Tariff Basket

Ge nd
rm OE itze
an
y CD rlan
Telecommunications Regulation Handbook

F av d
Ne ran er
w c ag
Ze e Fr e
al
a an
A nd Ge ce
OE ust
CD rali Un rma
a ite ny
av d

Fixed Charges Usage Charges

er St
Fixed Charges Usage Charges

ag at
es
Ire e
lan Ita
d l
Gr y
Sw Ita ee
ly ce
itz Au
er
la Ne
w
str
Be nd i
Ze a
Cz
ec lg al
h ium an
Re Au d
pu str
bl a
ic Cz Hu lia
Au ng
str ec a
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Gr a Re ry
ee pu
c b
Hu e Po lic
ng rtu
a ga
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Po ry Sp
rtu ain
ga
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Sp lan
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Po Me
lan xic
d o
 Module 4 – Price Regulation

Figure 4-7: Index of OECD Tariff Rebalancing, by year- The "Death of Distance"

1998 1990

2500 2500

2000 2000

1500 1500

1000 1000

500 500

0 0
3 km 7 km 12 km 17 km 22 km 27 km 40 km 75 km 110 km 135 km 175 km 250 km 350 km 490 km
Note: 3km call charge = 100

Source: OECD (1999)

Price Regulation
Figure 4-8: Index of OECD Residential Charges and Teledensity

T o ta l C h a r g e s Usa g e C h a rg e s F ixe d C h a r g e s T e le d e n s it y

130

120

110

100

90

80

70

60
1990 1991 1992 1993 1994 1995 1996 1997 1998
Notes: All indices set to 100 in 1990
Average weighted by number of access lines.
Calculation based on PPPs expressed in US$
Source: OECD (1999)

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Telecommunications Regulation Handbook

Appendix 4-2: Welfare Benefits of Rate Rebalancing

This Appendix provides an overview of the potential Table 4-10 provides a summary of the main esti-
benefits to public welfare that may be expected from mates used in the model. By way of explanation, the
rate rebalancing. unit of measurement for access is connections. For
local calling, it is number of calls, for long distance
The OECD study of telecommunications price trends and international calling, it is minutes. Net revenue is
(Appendix 4-1) indicates that rate rebalancing pro- the difference between price and cost (LRIC) times
vided most consumers with lower prices in a majority the quantity. For instance, the net revenue loss for
of the countries surveyed. This is not the only benefit residential access of $614 million is equal to the
of rebalancing. Rate rebalancing will also increase difference between price $139.80 and LRIC
social welfare by moving prices closer to costs. This $235.00, times 6.45 million connections. Note that
will provide benefits to the economy in addition to the sum of the net revenue is $2,909 million, which
those that result in lower overall prices. Rate rebal- we later assume to be its net revenue requirement.
ancing, therefore, should be undertaken whether
competition is being considered or not. The price elasticity of demand was based on a
review of available estimates that were considered
Regulators may be requested to justify rate appropriate for national conditions. With the
rebalancing. The recent modelling of rate exception of local calling elasticity, the estimates are
rebalancing that carried out in Australia may be within the intervals discussed in the Appendix B of
useful in this regard. The model was prepared for the Handbook.
Australia’s incumbent operator, Telstra, to estimate
the potential efficiency gains from different The concept of efficiency loss requires some expla-
rebalancing scenarios. Similar analyses have been nation. It is based on the theory that marginal cost
carried out in other countries. This example uses a pricing is optimal, that is, it maximizes the sum of
number of concepts, including long run incremental consumer and producer surplus. (This concept is
costs (LRIC), demand elasticities, revenue discussed in Appendix B of the Handbook.) When
requirement, and Ramsey Pricing, which are prices do not equal marginal costs, there are effi-
discussed in Appendix B of the Handbook. ciency losses because either consumer or producer

Table 4-10: Estimates Used in the Telstra Rate Rebalancing Model – Base Scenario

Net Price
Price LRIC Efficiency
Markets Quantity Revenue Elasticity of
($ per unit) ($ per unit) Loss ($m)
($m) Demand
Res. Access 139.80 235.00 6.45 m -614 8 -0.04
Bus. Access 240.00 235.00 2.76 m 14 0 -0.00
Local calls 0.232 0.099 11.20 b 1492 26 -0.006
Dom. LD calls 0.311 0.124 9.51 b 1782 322 -0.60
Intntnl. Calls 1.129 0.759 638.00 m 236 46 -1.20
Total 2909 402
Source: Australia Productivity Centre (1997)

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 Module 4 – Price Regulation

surplus are reduced. Figure 4-9 provides a graphical $402 million, or nearly 15% of total operator
presentation of the main estimates used in the revenues. Note, however, that while marginal cost
analysis. The black shaded areas are the efficiency pricing will eliminate this loss in economic efficiency,
losses associated with each instance of non- it will not meet Telstra’s net revenue requirement,
marginal cost pricing. Note that efficiency losses which is assumed to be equal to $2,909 million. As
increase when the price-cost disparity is greater and discussed in Appendix B of the Handbook, the solu-
when demand is more elastic. (Note the light shaded tion to this dilemma is to calculate the corresponding
areas represent net revenues for each service). Ramsey prices, that is, the set of prices that
minimize efficiency losses and meet the revenue
The price-cost gap at initial conditions (the base requirement.
scenario) imposes a loss in economic efficiency of

Figure 4-9: Rate Rebalancing - Base Scenario

R esidential access (connections) Business access (connections)

$ $

P = 240
LRIC = 235
LRIC = 235
P = 139.80

6.45m 2.76m

Price Regulation
Local Calling (calls) Dom estic LD Calling (m inutes)
$ $

P = 0.311
P = 0.232
LRIC = 0.124

LRIC = 0.099

11.2b 9.51m

International Calling (m inutes)

P = 1.129

LRIC = 0.759

638m

Note: Figures are not to scale.

Source: Australia Productivity Centre (1997)

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Telecommunications Regulation Handbook

Table 4-11 presents the results of five rebalancing Scenario #2 holds the business access price to
scenarios, with the corresponding net revenue con- $350 and calculates the constrained Ramsey prices.
tribution and efficiency losses, and contrasts these Scenarios #3, #4, and #5 are other permutations
to the base scenario. that put further constraints on prices. Note that the
more constraints that are placed on Ramsey prices,
Scenario #1, which totally eliminates the efficiency the smaller the efficiency gains. Note also, however,
loss, would appear to be an extreme case. Ramsey that even modest price movements towards LRIC
prices call for the highest price over cost mark-up for can result in significant efficiency gains. These gains
the least price-sensitive service. In this instance, are likely to be greater in developing countries
business access price is raised to $1,287 and because of the generally greater disparity between
contributes the entire net revenue of $2,909 million prices and costs.
because it has an estimated zero price elasticity.

Table 4-11: Results of Rate Rebalancing Scenarios

Variable Residential Business Local Domestic International Total

Access Access Calls LD Calls Calls
Scenarios LRIC $ 235.00 235.00 0.099 0.124 0.759
Base Scenario Price ($) 139.80 240.00 0.232 0.311 1.129
Net. rev ($m) -614 14 1492 1782 236 2909
Eff. Loss ($m) 8 0 26 322 46 402
Scenario 1: Price ($) 235.00 1287.00 0.099 0.124 0.759
Unconstrained
Ramsey Pricing Net. rev ($m) 0 2909 0 0 0 2909
Eff. Loss ($m) 0 0 0 0 0 0
Scenario 2: Price ($) 354.00 350.00 0.235 0.148 0.804
Constrained
Ramsey Prices Net. rev ($m) 723 318 1529 301 38 2909
Eff. Loss ($m) 13 0 27 5 0 45
Scenario 3: Price ($) 235.00 350.00 0.291 0.158 0.822
Constrained
Ramsey Prices Net. rev ($m) 0 318 2120 418 53 2909
Eff. Loss ($m) 0 0 54 10 1 65
Scenario 4: Price ($) 235.00 350.00 0.232 0.209 0.919
Constrained
Ramsey Prices Net. rev ($m) 0 318 1492 975 124 2909
Eff. Loss ($m) 0 0 26 67 8 101
Scenario 5: Price ($) 140.00 350.00 0.232 0.272 1.036
Constrained
Ramsey prices Net. rev ($m) -614 318 1492 1520 194 2909
Eff. Loss ($m) 8 0 26 203 25 262
Source: Australian Productivity Centre (1997)

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