Are there differences between cost models in retail vs. interconnection pricing?

[Response by Eric P. Chiang, May 2009]

It is important to note some differences in the use of LRIC in retail vs. interconnection pricing. The most important difference is that there are no stand-alone¹ costs in interconnection. This is because a telecommunications operator provides interconnection only if it also provides retail services, that is to say, interconnection is never a stand-alone service.

In the retail setting, if we have two services, each with a stand-alone cost of production, the overhead (shared costs) is the sum of the stand-alone costs less the total cost of producing both services together. The incremental cost (i.e., LRIC) of one good is calculated as the total costs of producing both services together less the stand-alone cost of producing the other good.

Returning to the calculation of LRIC in interconnection, we are comparing costs when an incumbent is 1) interconnected and 2) not interconnected. Thus:

This states that the long-run incremental cost of interconnection is equal to the total cost of providing both retail and interconnection together, minus the cost of just providing retail services. Thus, LRIC(I) is just the additional (incremental) cost of providing interconnection rather than only retail services.

Note another difference with the retail case: given that there is a single service that is either interconnected or not interconnected (rather than two distinct products in the retail case), charging interconnection prices equal to LRIC does not result in negative profits. Thus, as long as LRIC is charged, the incumbent costs should be covered. However, this also means that the incumbent will not profit either. Thus, a mark-up is often built into interconnection prices.
 

Footnotes

1. Stand-alone cost: A firm’s total cost of a producing a single component or service (or sometimes a group of services) by itself.