Theory and Application of Subsidy-Free Prices

  • Mark A. Jamison
Part of the Studies in Industrial Organization book series (SIOR, volume 22)


The regulation of utility prices has long addressed issues of cross-subsidization. Views on the meaning of cross-subsidization have varied, but they have generally involved the idea that one set of customers receives favorable prices at the expense of other customers. Faulhaber (1975, p. 966) and Baumol (1979, p. 242) note that cross-subsidization issues existed as long ago as the late 1800s for railroad pricing in the US. In the early part of the 20th century, Glaeser (1939) addressed cross-subsidy issues for allocating joint costs in the Tennessee Valley Authority. US State regulators expressed cross-subsidy concerns in the 1950s and 1960s, during the early development of Separations, the process by which regulators and companies allocate telecommunications costs between the State and federal jurisdictions in the US. The FCC and the telecommunications industry also expressed concerns, but they often disagreed with the State regulators on the direction of the subsidy flow. (Jamison 1999b)


Incremental Cost Cost Test Joint Production Alternative Supplier Price Floor 
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  1. 1.
    Prices are set according to the inverse elasticity rule if “for each service the percentage deviation of quasi-optimal price (is) inversely proportionate to its own price elasticity of demand.” (Bonbright, Danielsen, and Kamerschen 1988, p. 533)Google Scholar
  2. 2.
    I explain later in this chapter why in some circumstances it is unnecessary to test all subsets of the utility’s products.Google Scholar
  3. 3.
    As I explain in more detail later in this chapter, it may be obvious that some products share few if any costs, making it unnecessary to perform formal tests of their prices as a group.Google Scholar
  4. 6.
    Generally I suppress notation showing that demand for a product is a function of its own price.Google Scholar
  5. 7.
    In an earlier paper (Jamison 1996, pp. 381–382), I analyze how an inefficient firm might constrain subsidy-free prices for an efficient firm. In retrospect, I should have included a subsidy for the inefficient firm. My analysis in this chapter corrects this error.Google Scholar
  6. 8.
    Because of the assumption of contestable markets, all technologies are freely available to all firms. This makes it unnecessary to use notation to identify a cost function as belonging to a particular firm.Google Scholar
  7. 11.
    That this is equal to each town’s incremental cost is simply an anomaly of this example.Google Scholar
  8. 12.
    When demand interdependency is ignored, stand-alone cost is called gross stand-alone cost and incremental cost is called gross incremental cost.Google Scholar
  9. 13.
    This would also apply in the Faulhaber framework, but has not been discussed in the literature.Google Scholar
  10. 14.
    Susan S. Hamlen, William A. Hamlen, Jr., and Tschirhart (1977) provide a good explanation of the application of core theory.Google Scholar
  11. 15.
    In this system, the well is in the center of the triangle. It is 2.3 miles from each town, so there are 6.9 miles of transport.Google Scholar
  12. 16.
    See, for example, William E. Taylor (1995, pp. 15–16); Kolb (no date, pp. 1258–1259); Oregon Public Utility Commission (1997, p. 179) citing US West’s arguments; and Southwestern Bell (1994, p. 2).Google Scholar
  13. 17.
    The Trebing model: (I) limits economic regulation to markets with residual monopoly power where competition does not appear to be sustainable; (2) incorporates clear welfare guidelines for social policies pursued through regulation, such as pricing for universal service; and (3) uses regulation of market structure to stimulate competition where feasible. This model could be viewed to assume more stable technologies and markets than we have today. Also, its third element should be adapted to reflect the revolution in market structure that liberalization of telecommunications markets has unleashed. Given these, an appropriately modified Trebing model would appear to have the following elements (Jamison 1999b): engaging in normal economic activity. 2. Explicit welfare objectives and transparent welfare mechanisms that do not distort the competitive market process. 3. Removal of regulatory barriers, based on geography, technology, or other boundaries, that limit companies’ markets and their abilities to merge and divest. One of the key differences between this modified Trebing approach and the Faulhaber stand-alone cost test is that the modified Trebing approach incorporates welfare and other social objectives, which the Faulhaber tests omit. (Faulhaber 1975, pp. 967) The modified Trebing approach considers welfare and social objectives in pricing and pursues these objectives in ways that do not interfere with competition or deregulation.Google Scholar
  14. 18.
    This may not be true for all USOs. The obligations in the US may not be symmetric among all competing USO providers. In the past, some regulators have required incumbent local exchange carriers to maintain an uneconomic level of infrastructure in order to stand ready to serve or to place a nonremunerative technology in order to facilitate community or economic development. Continuation of these obligations without either the regulator or the market placing a symmetric burden on new entrants, will make this portion of the US USOs be of the single-provider type.Google Scholar
  15. 19.
    Federal Communications Commission, Federal-State Joint Board on Universal Service, CC Docket No. 96–45, and Forward-Looking Mechanism for High Cost Support for Non-Rural LECs, CC Docket 97–160, Further Notice of Proposed Rulemaking,FCC 97–256 (rel. July 18, 1997), par. 1 (FNPRM).Google Scholar
  16. 20.
    Federal Communications Commission, Federal-State Joint Board on Universal Service, CC Docket No. 96–45, Report and Order, FCC 97–157 (rel. May 8, 1997), par. 6 (Order).Google Scholar

Copyright information

© Springer Science+Business Media New York 2000

Authors and Affiliations

  • Mark A. Jamison
    • 1
  1. 1.Public Utility Research CenterUniversity of FloridaGainesvilleUSA

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