It is often the case that a new entrant into a market, seeking to attract business away from an incumbent operator, will need access to certain shared and/or 'downstream' services. Shared services are, for instance, railway tracks and the electricity grid. Downstream services are those nearer the final consumer. Examples include the provision of pipes and wires to the home, and postal deliveries.
It is often necessary for the regulator to set the prices to be paid for use of those services, so as to ensure that the incumbent operators do not charge their rivals so much that new entrants cannot compete. A number of different approaches can be taken, but the best is often cost plus, the third of the approaches described further below.
1. It can sometimes be appropriate to charge the average cost of providing the service, including overheads, before the new entrant arrives on the scene. The trouble with this approach is that it passes on to the new entrant the cost of the inefficiency of the incumbent - which may be substantial as the incumbent will have faced little or no pressure from competitors. This approach therefore tends to deter entry.
2. Another approach is to adopt the Efficient Component Pricing Rule (ECPR) otherwise known as retail minus. Under this approach, the price charged is the marginal cost of taking on the new business plus the likely reduction in the incumbent's profits as a result of losing business to the new entrant - which is the same as the incumbent's final product price less the costs it would avoid by providing access. The incumbent thus recovers all his common and fixed costs, including 'sunk' costs, as well as a return on capital. This rule was developed in the 1990s by Professors Baumol and Willig in the USA, and is sometimes known as the Baumol-Willig rule. The trouble with ECPR is that it strongly deters entry because:
- The incumbent makes the same profit irrespective of whether the new entrant enters the market or not. The entrant in effect pays the incumbent in perpetuity for all the revenues (including profits) that the incumbent had previously received, less only the costs which the incumbent has avoided as a result of the fact that it is the new entrant, rather than the incumbent, which is now supplying the customer.
- Whatever excess profits or inefficiencies are present in the retail price are therefore simply preserved in the access price. And the the incumbent's costs and profits may be very high if they are exercising monopoly power.
- Because the calculation of avoidable cost directly affects the access charge, under ECPR the risk of cost manipulation by the incumbent is significant.
- Because avoidable costs are based on forward looking assumptions, such costs are inherently uncertain, depending on the time period used and the output increment assumed.
3. It can therefore make a lot of sense to adopt a third approach:- cost plus. This involves calculating the marginal cost of providing the service - assuming the incumbent is efficient - and then adding a contribution to the incumbent's overheads, but excluding costs which are personal, so to speak, to the incumbent. Such excluded costs will include sales and marketing, corporate head offices, and directors' salaries. This approach can lead to surprisingly low access prices, as the marginal cost in a network industry can be very low, whilst bloated incumbents often have high central corporate costs. This cost plus approach can therefore be a very good and essentially fair way of encouraging access by new entrants.