An analysis of price cap regulation and its application in Australian telecommunications

Abstract

Price cap regulation establishes a regulatory framework which endeavours to use the superior information and profit maximising tendencies of the regulated firm to induce it eventually to obtain productive and allocative efficiency. A price cap is a specific limit on a weighted sum of the prices set by the regulated firm in each period which ensures that constrained profit maximising price changes increase a measure of consumer surplus. The long-run efficiency properties of the different types of price caps depend, inter alia, on whether the limit on changes is based on cost or revenue, the basis of the weights on price changes, the planning horizon of the firm, structure of prices set by the firm, and the stability of costs and demands. The economic literature on price cap regulation is reviewed, and extensions of the simple models consider the problems of indexing for changing costs and demands, the consequences of applying the cap only to a sub-set of the outputs of the firm, the division of previously uniformly-priced products and the introduction of new services. Regulatory reforms of the Australian telecommunications industry commenced in 1989, and included two triennia of price cap regulation applied to the Australian Telecommunications Corporation (Telecom), the Overseas Telecommunications Corporation (OTC), and to the corporation formed by their merger in 1992. The first triennium applied a form of a past revenue-based price cap, indexed for inflation and changes in cost. The second triennium modified the arrangements of the first by, inter alia, adopting anticipated revenue shares to weight the sum of price changes. The efficiency properties of these specific forms of price caps are analysed in the light of existing theory, and the properties of the form of the second triennium price cap are derived. In particular, the set of feasible prices under the second triennium cap depends on the structure of demands. Consequently, the forms of the first and second triennium price caps are identical only in a special case, and in more general circumstances the anticipated revenue-based price cap can leave the firm either more tightly or loosely constrained than under the past revenue-based cap. Sufficient conditions for these cases are described, along with their efficiency consequences, and the generalisations to account for two-part prices and multi-period profit maximisation are considered. The arrangements for, and changes in prices during, the two triennia are assessed in the light of available empirical evidence and the theoretical analysis. Changes in relative prices are consistent with the predictions of the models of the price caps, and with a priori expectations of a more efficient structure. The indexation factors used in both triennia were set too low, and larger rates could have been set to pass the benefits of decreases in costs on to consumers as lower tariffs. The generally inelastic nature of demands for telecommunications services means the second triennium cap imposed a tighter constraint on regulated prices than would a similarly indexed version of the first triennium cap. However, it is not clear that price cap applied in the second triennium will necessarily lead to improvements in the efficiency of regulated prices compared with those which may have been achieved by continuing the arrangements of the first triennium. Show more