Ramsey Pricing in Telecommunications Markets with Free Entry

Abstract

A standard normative model of optimal regulated pricing is Ramsey pricing. Ramsey prices are those prices which maximise the indirect social welfare function subject to the regulated firm breaking even at those prices. Faulhaber (1975), first observed that requiring a regulated multi-product monopoly to use Ramsey pricing may be incompatible with allowing free entry into some of the regulated firm’s markets. He argues that, in general, Ramsey prices produce cross-subsidisation in that if the cost function describing the monopolist’s technology is additively separable — hence the average cost of production for each product is well defined — then in some markets the Ramsey prices exceed the average cost of production and in other markets (the subsidised markets) the Ramsey prices are less than the average cost of production. Consequently, firms will enter those markets which are being taxed relative to the average cost of production and produce those commodities at a price less than the Ramsey price. This will leave the regulated firm with insufficient revenue to subsidise consumption in those markets where it is pricing below average cost. The resulting mix of regulated prices and market prices will not be socially optimal.