Pricing communication networks P13

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Pricing communication networks P13 Pricing Communication Networks: Economics, Technology and Modelling. Costas Courcoubetis and Richard Weber Copyright  2003 John Wiley & Sons, Ltd. ISBN: 0-470-85130-9 13 Regulation The regulator’s job is to supervise a market so that it operates efficiently. He acts as a high level controller who, taking continual feedback from the market, imposes rules and incentives that affect it over the long term. In the telecoms market the regulator can influence the rate of innovation, the degree of competition, the adoption of standards, and the release to the market of important national resources, such as the frequency spectrum. The efficiency of an economy can be judged by a number of criteria. One criterion is allocative efficiency. This has to do with what goods are produced. The idea is that producers should produce goods that people want and are willing and able to buy. Another criterion is productive efficiency. This has to do with how goods are produced. The opportunity cost of producing any given amounts of products should be minimized. Resources should be used optimally. New technologies and products should be developed as most beneficial. Finally, distributive efficiency is concerned with who things are produced for: goods should be distributed amongst consumers so that they go to people who value them most. In general, competitive markets tend to produce both allocative and productive efficiency. However, in cases of monopoly and oligopoly firms with market power can reduce effi- ciency. We say there is market failure. In this case, regulation can provide incentives to the firms with market power to increase efficiency. The incentives can either be direct, by im- posing constraints on the prices they set, or they can be indirect: for example, by increasing the competitiveness of the market. There is no single simple remedy to market failure. Sometimes competition actually reduces allocative efficiency. In the case of a natural monopoly, social welfare is maximized if a single firm has the exclusive right to serve a certain market. This is because there are large economies of scope and scale, and because the rapid creation of industry standards leads to efficient manufacturing and also to marketing of complementary products and services. We see this in traditional telephony, and other public utilities, such as electric power, rail transportation and banking. The job of the regulator is to ensure that the monopolist operates efficiently and does not exploit his customers. Information plays a strategic role in the regulatory context, because regulated firms can obtain greater profits by not disclosing full information about their costs or internal operations. A principal difficulty for the regulator is that he does not have full information about the cost structure and the production capabilities of the firm, nor does he know the actions and effort of the firm. This is another example of the problem of asymmetric information, already met in Section 12.4 in the context of interconnection contracts. We illustrate this in Section 13.1, with some theoretical models, and then explain ways in 292 REGULATION which the regulator can achieve his goals despite his lacking full information. The firm’s information about the future behaviour of the regulator may also be imperfect; this leads to intriguing gaming issues, especially when decisions must be made about large, hard to recover investments. In Section 13.2 we describe some practical methods of regulation. Section 13.3 considers when a regulator ought to encourage competition and how he can do this. In Section 13.4 we discuss the history of regulation in the US telecommunications market and describe some trends arising from new technologies. 13.1 Information issues in regulation 13.1.1 A Principal-Agent Problem In this section we present a simple model for the problem of a regulator who is trying to control the operation of a monopolist firm. Unless he is provided with the right incentives, the monopolist will simply maximize his profits. As we have seen in Section 5.5.1, the social welfare will be reduced because the monopolist will tend to produce at a level that is less than optimal. The regulator’s problem is to construct an incentive scheme that induces the firm to produce at the socially optimal level. We can use the principal-agent model with two players to illustrate various problems in constructing incentives and the importance of the information that the regulator has of the firm. Recall, as in Section 12.4, that the principal wants to induce the agent to take some action. In our context, the principal is the regulator and the agent is the regulated firm. The firm produces output x, which is useful to the society, and receives all of its income as an incentive payment, w.x/, that is paid by the regulator. In practice, firms do not receive payments direct from the regulator, but they receive them indirectly, either through reduced taxation, or through the revenue they obtain by selling at the prices the regulator has allowed. To produce the output, the firm can choose among various actions a 2 A, and these affect its cost and production capabilities. There are two types of information asymmetry that can occur. The first is known as hidden action asymmetry and occurs when the regulated firm is first offered the incentive contract and is then free to choose his action a. The level of outputP takes one of the x values x1 ; : : : ; x n , with probabilities p1 ; : : : ; pn , respectively, where i pia ...