Guide to Cross-

Subsidization & Price

Predation: Ten Myths
Session 14a

Dr. Sanford Berg

Director of Water Studies, PURC

From Telecommunications Policy, August 1992,

by Berg and Dennis Weisman)
 Basic Economic
Principles
Product X is being subsidized by
product Y if the price for product Y
is set above its incremental cost
so that the price for product X can
be set below its incremental cost
Efficient Output Level as
Benchmark
Demand reflects the marginal
benefit or marginal valuation at
that output level.
Marginal (or incremental) cost
reflects the opportunity cost of
resources in alternative activities.
Misallocation or deadweight losses
if P<MC : Overconsumption
P>MC : Underconsumption
 Simple Example
Price Price Demand

Pb Y
LRICa LRICb
X
Pa
Demand

Qa Quantity Qb Quantity
 Interpretation
If total revenue from markets a and b cover
total costs, but the price of a is less than
incremental cost and the price of b is greater
than incremental cost, there are two
misallocations from inefficient pricing:
X represents resources devoted to production
where the output is valued less than
incremental costs;
Y represents lost benefits when price is above
incremental cost.
Here the firm is made whole.
 Evaluation
Impacts on efficiency

Impacts on fairness

Myths can point to ultimate truths, but

they can be applied incorrectly
breeding confusion.
 Myth 1
Myth 1: Cross subsidies are always
inefficient.

Yet externalities in consumption (eg.

Access to water and health
implicationscontagious diseases,
Also social valuations placed on
additional consumption by the
deserving poor
 Myth 2
Myth 2: when regulators correct
inefficiencies and inequities, the best
policy, from an efficiency perspective,
involves raising the prices of the
most inelastic regulated services.
Standpoint of the market vs. standpoint
of the individual firm
Recognize the role of new entrants
Minimizing output distortions has merit,
but may conflict with incentives to
introduce substitute products in Long Run
 Myth 3
Myth 3: To ensure against the flow of
cross-subsidies, it is sufficient that the
price for an individual service cover its
corresponding incremental cost.
Merely a necessary condition.
If substitutes, the incremental revenues
associated with adding X to the product line
must be reduced to reflect the reduction in
the demand for Y.
Beware of simplistic/arbitrary fully
distributed cost
 Myth 4
Myth 4: Protection against cross-subsidization
requires that the minimum and maximum
pricing rules hold at each point in time.
Demonstration effects: serve to shift the demand
curves out in period two after consumers have
gained experience with the product.
Learning curve effects: Costs are lower in the
second period, based on the quantity produced in
the first period.
Period by period vs. life cycle of product or product
line
Long run marginal cost pricing standard (over the
time horizon)
 Myth 5
Myth 5: Separate subsidiaries (ring
fencing) protect core consumers
from high prices used to subsidize
non-core competitive services.
Cure can be worse than the disease
(lost economies of scope or sequence)
Product groups, product families,
product divisionsdetailed
information?
 Myth 6
Myth 6: Setting price floors on the
basis of average cost is sufficient for
the prevention of predatory pricing.
Multiproduct firms will have some shared
inputs.
Areeda and Turner: short run marginal
cost standard.
Baumol: average variable cost standard
(or average gross incremental cost)
 Myth 7
Myth 7: The incentives to engage in
price predation are the same under
both price cap and traditional rate of
return regulation.
Gains from cost shifting are largely
eliminated under price cap regulation
(though ROR used for new P0
Quasi-permanent pricing rule for the
incumbent (to level the playing field)
Survival should be on basis of relative
efficiency.
 Myth 8
Myth 8: Setting prices on the basis of fully
distributed costs is the only way to definitely
protect against the flow of cross-subsidies and
ensure that the public interest is served.
Captive rate-payers are actually hurt by fully-
distributed costing methodology because of the
increase revenue burden they must bear due to the
elimination of other offerings that would have
contributed to the shared costs of the firm.
Averages do NOT adequately reflect the incremental
nature of the relevant costs (cost causality).
 Myth 9
Myth 9: If the price of a service is set
so high that it fails the stand-alone
cost test, prices are not subsidy-
free.

The above is correct only when the firm

is subject to a binding zero profit
constraint.
 Myth 10
Myth 10: In a natural monopoly market it is
always possible to find a set of prices that (a)
is subsidy free, (b) allows the firm to break
even, and yet (c) is sustainable against
competitive entry.
Sustainability is not guaranteed (e.g. C( ) is cost)
C(a) = C(b) = C(c) =C(d) = $15
C(a,b) = C(a,c) = . . . =C(c,d) = $25
C(a,b,c)=C(a,b,d)=. . .=C(b,c,d)=$30
C(a,b,c,d)=$44
Natural monopoly for four customers, but coalitions
have incentives to break away to join entrant.
 Myth 10 continued
The example illustrates the possible
incentives for coalitions to develop and build
stand-alone systems.
There is a potential role for entry
restrictions (if the dynamic effects are
minimal, administrative costs are small, and
incentive problems are addressed.
Jamison: Need to check all possible product
combinations for multi-product firmsso the
likelihood of natural monopoly is reduced
(and difficult to determine).
Concluding Observations
The issues of cross-subsidization and
price predation are in some sense, one
and the same. Cross-subsidization
represents a natural way in which a
firm could finance predatory pricing.
Incentives within regulated industries
present constraints on firms.
Price caps applied properly may protect
against predatory pricing.
Concluding Observations
Continued
Policy makers need to distinguish
between legitimate checks on
monopoly power and attempts by
potential entrants to require
inappropriate cost allocations schemes
or artificial organizational structures
that would restrict organizational
structures that would restrict otherwise
socially beneficial competition.
 More Recent Issues
Shavel: Raising rivals costs
Sappington and Weisman: Sabotage
Jamison: Identifying natural monopoly
based on economies of scope when a
number of technology platforms and
product groupings are possible.
Pollitt: gaming the regulator
Chicago School: Does predation make
economic sense?