Pricing in Competitive or Partially Competitive Environments

In most countries, utility service¹ prices prior to market reforms were based on political considerations and not on underlying costs. Examples include subsidized electricity prices and high international telecommunications prices used to subsidize other services, fund the country’s treasury, or provide hard currency to the government. Politically-based prices are unsustainable when competition is allowed because entrants target the subsidy-providing customers and subsidized markets are ignored. As a result, there is often a need to rebalance prices when markets are open to competition. Rebalancing means that prices are aligned closer to their marginal costs. Rebalancing prices can adversely affect some customers, so regulators need to consider whether these effects make certain aspects of rebalancing unsustainable politically and whether certain aspects of the rebalancing conflict with regulatory objectives.

Price flexibility, forbearance, and deregulation are also important when there is competition. If market forces are to work, operators need the ability to respond to market changes, expect extra profits when they make good decisions in the marketplace, and experiment with ideas. If regulators are reluctant to deregulate prices in competitive markets but nonetheless want to allow the operator to respond to competitive pressure, they will sometimes use forms of price regulation for those markets to allow price flexibility. Examples of approaches include establishing a service basket² for nearly competitive services, establishing price floors based on incremental cost or imputation, and banded prices. Imputation is used in instances where the operator provides an essential facility³ that its rivals need in order to compete in the nearly competitive market. Imputation is a process that in effect requires the operator to reflect in its competitive prices the price it charges its rivals for using the essential facility. Banded prices are simply upper and lower bounds, between which the operator can change prices as it wishes. The lower band is typically based on incremental cost.

Regulators or policy makers often adopt policies of forbearance or deregulation when competition is sufficient to constrain operators’ abilities to raise prices enough to receive economic profits.⁴ Forbearance is generally the situation where the regulatory has authority to regulate prices but chooses to not do so. Deregulation is generally the situation where the regulator lacks the authority to regulate prices.

The regulator might also be concerned about protecting customers of non-competitive services from providing cross-subsidies to the operator’s competitive operations. The regulator might address this problem with ring fencing, the price floors described above, or with pure price cap regulation for the non-competitive services.⁵

Footnotes

1. See reference section for the effect of competition on decisions regarding Tariff Rebalancing, Cross-Subsidization, and Funding of Social Obligations. The section on market structure and competition reviews competition.
2. The section on Price Regulation describes service baskets.
3. See the reference section for Approaches to Competition for more information about essential facilities.
4. The section on Factors Leading to Monopoly notes assessing market power.
5. The reference sections for Principles and Price Regulation describe pure price cap regulation.