Cost models: Comporting with principles

Abstract

Recent public policy initiatives in telecommunications prescribe tying certain prices and subsidies to cost. The apparent motive behind these policies is a desire to mimic competitive outcomes when markets are too frail to be trusted with the task of achieving economic efficiency. Indeed, it is true that an outcome of “perfect competition” as portrayed in university textbooks has all prices equal to respective marginal costs. However, the conditions behind this relationship include an onerous requirement that all markets be present and operating. Missing in telecommunications are markets for the present and future use of the network capacity created by both incumbent and new firms. Just as “real options” in financial markets allow for the present trading of future options to purchase financial securities, options to presently trade future network capacity would greatly improve the incentives to build optimal network capacity. In addition, such options would provide a mechanism to realize present financial rewards for the expected future value of those networks. Yet economic efficiency requires that prices reflect the option costs in addition to the costs of productive resources. Because the “cost” of capacity options is not available today, any attempt to link regulated prices to resource costs could result in prices very different than market prices. Perhaps the wiser public policy is to encourage the development of present and future capacity markets, complete with associated real options.