PRICING FOR INFRASTRUCTURE ACCESS

Dr. Stephen P. King

Competition and Regulatory Policy Program

Center for Economic Policy Research

Research School of Social Sciences

Australian National University

I. THE ECONOMIC FOUNDATIONS OF ACCESS PRICING

Before discussing appropriate methodologies for pricing access to essential

infrastructure facilities, it is necessary to answer some preliminary questions.
First, why do we care about infrastructure access? Secondly, even if we care
about access, why should we care about the price charged for access services?
Thirdly, what basis should be used to determine whether one set of access
prices are better or worse than another set?

A. ESSENTIAL FACILITY ACCESS

Infrastructure access, through both the new Part IIIA of the Trade Practices
Act 1974, and the Competition Principles Agreement, provides a solution to
the 'essential facilities' problem.1 While much of National Competition Policy
involves the removal of barriers to competition, there may be circumstances
where competitive production is inefficient. If production involves
increasing-returns-to-scale technology, or more generally a natural monopoly
technology, then it is always more efficient to have only a single firm or
facility involved in all relevant production. In such circumstances,
competitive production will lead to excessively high costs and a waste of
social resources.2

However, the existence of natural monopoly technology does not immediately

imply that there is a problem with competition. While competitive production
of the relevant good or service (which may itself be an input into further
production) is wasteful, the owner of an unregulated natural monopoly facility
may be constrained by competition from other products. If the good or service
produced by a natural monopoly facility is merely one of a number of products
that are reasonably close substitutes then there may be little or no scope for
monopoly abuse.

As an example, consider residential gas distribution. It is reasonable to

suggest that such distribution involves a natural monopoly technology.
Production costs are likely to be minimised if each house is serviced by only a
single low pressure pipeline controlled by one firm. Efficient production
dictates that gas distribution is controlled by a monopoly service provider. If
gas is simply one product in a larger market for "fuels and energy sources",
then retaining an unregulated monopoly gas distributor may provide little
concern. While gas distribution involves a natural monopoly, the owner of the
gas distribution network will have little or no monopoly power if other fuel
sources, such as electricity and oil, provide ready substitutes.

In contrast, if there exists a separate gas market, where consumers have little
ability to substitute between fuel sources, then the existence of natural
monopoly technology in gas distribution may raise significant concerns.3

A firm with natural monopoly technology only creates regulatory problems if

it either has substantial power in a final product market or if it provides an
essential input to either upstream or downstream production processes. It is
this latter case which leads to the 'essential facility' problem

An essentiality facility involves two distinct characteristics. First, the relevant

product involves a natural monopoly technology, so that it is always socially
efficient to have a single producer. Secondly, the product is essential to final
market production. The product must be essential to the manufacture of
another good or service in that there does not exist an alternative input or
production process that can enable a competitor to produce an equivalent final
good or service at a comparable cost. In addition, the product is only essential
if there does not exist an alternative final good or service that is able to be
supplied at a competitive price without that input.4
Essential facilities provide a problem for policy makers. Allowing
competition in the provision of the natural monopoly product may lead to
socially wasteful facility duplication. At the same time, in the absence of any
effective competition, a firm that controls an essential facility will be able to
exercise considerable monopoly power, to the detriment of consumers and
economic welfare.

The Hilmer Report approached the essential facility problem by

recommending a regulated access regime. If a facility produces a service
which is both characterised by natural monopoly technology and is essential to
competition in another market, then the owner of the facility must allow other
firms access to that service. This recommendation formed the basis of the
access regimes included in the Trade Practices Act and the Competition
Principles Agreement.5

B. PRICING AND ESSENTIAL FACILITY ACCESS

Requiring access, by itself, is insufficient to prevent the owner of an essential

facility from abusing his market power to reap monopoly profits. While
access will aid entry into relevant downstream or upstream markets, the
facility owner will be able to seize all available monopoly profits by choosing
appropriate pricing schemes for access.6

For example, consider the case of an infrastructure owner who controls an

essential input for downstream competition. If the infrastructure owner is
required to provide access to other firms, then he can no longer monopolise
the downstream market. But this does not mean that the owner need forego
any monopoly profits. Rather than reaping monopoly profits directly from the
downstream market, the facility owner can simply seize those profits upstream
by setting appropriate access prices. If he believes that there will be many
firms seeking access, resulting in strong downstream competition, then the
facility owner merely needs to charge a sufficiently high price for access to
garner all available profits. If he believes that there will only be weak
competition downstream, then the facility owner can lower the per unit price
for access to encourage downstream price competition while seizing all
available profits by charging each access seeker an appropriate upfront fee.
Requiring a facility owner to provide access is unlikely to substantially reduce
his market power. Additional measures will be required to overcome the
essential facility problem.

For example, if regulators impose price controls on relevant downstream

markets then the upstream facility owner will be indirectly constrained by
these controls. Total profits will be constrained by final market prices. While
the access provider can use a variety of schemes to seize all the available
profits, he cannot seize profits that are unavailable due to the final market
price controls.

Alternatively, regulators could impose profit constraints directly on the

infrastructure provider. The access regime recently proposed for electricity
transmission infrastructure by the National Grid Management Council
(NGMC) includes rate-of-return requirements that limit facility owners'
profits.7 While there has been significant debate over the form of profit
regulation chosen by the NGMC,8 to the degree that the rate-of-return
constraints are binding, owners of transmission facilities will have less ability
to abuse their market power.

Constraining the prices that can be charged for access can also remove a
facility owner's ability to abuse his market power. For example, restricting the
type of pricing schemes that a facility owner can use will often limit his ability
to seize profits from the downstream market.9

Using downstream price controls, constraining facility owners' profits or

limiting allowed access prices will all help to restrict abuse of market power
by an owner of an essential facility. To some degree, all these tools overlap.
For example, if there are effective downstream price controls then it is
unlikely to be necessary to directly restrict the upstream profits of an access
provider. These profits will be indirectly constrained by the regulated
downstream prices. Similarly, if an access provider is constrained by effective
profit regulation, then the actual structure of access prices may be irrelevant.10
However, in general, even if an access provider's profits are directly or
indirectly controlled, the access prices that he sets will have implications for
economic efficiency. Returning, for example, to the access regime proposed
by the NGMC, even if a transmission company is constrained by profit
regulation, there are many different pricing schemes that can be used for
access to the transmission system. While all of these schemes may lead to
identical profits for the transmission company, most of them will be inefficient
in that they will not provide correct incentives for access users. An efficient
access pricing scheme will not only prevent the transmission company from
abusing its market power, it will also provide incentives for generators to
choose an optimal location for their facilities, and provide consumers with
incentives to choose when to operate electrical equipment.

Access prices have two important roles. First, by restricting an access provider
to set appropriate prices for his services, regulators can constrain the ability of
an essential facility owner to abuse his market power and seize monopoly
profits. Secondly, setting appropriate access prices will provide both access
users and final good consumers with appropriate economic incentives.

C. JUDGING ACCESS PRICES

Pricing is arguably the most important element of an access regime. But how
should appropriate access prices be judged?

While economic efficiency provides one basis for comparison, there are at
least three separate and distinct aspects of economic efficiency that need to be
considered for access pricing. First, access pricing should promote productive
efficiency. This requires that access prices give both the infrastructure owner
and access seekers the correct incentives to produce their relevant outputs at
least cost. For example, if the access provider is required to always price at
average cost then he will have little incentive to operate his facility efficiently.
Rather, the access provider will find it beneficial to raise his average
production costs and take his profits as perquisites. Similarly, if the access
prices are averaged over all buyers rather than reflecting individual costs of
supply, then access seekers will have little incentive to choose their location or
production process to minimise the costs of obtaining access .

Secondly, access prices should promote allocative efficiency. Final product

prices should reflect the social cost of production. If the production process is
not congested, then consumer prices should reflect the resources used for
production. If production is constrained by congestion, then consumer prices
should reflect this congestion with the constrained output going to those
consumers who value it most highly.

Thirdly, access prices should promote efficient investment in new facilities

over time. If access prices are set so low that the facility owner cannot earn at
least a market rate of return on his investment, then he will have no incentive
to maintain his facility or invest in new facilities when appropriate.
Alternatively, if the infrastructure owner is able to price access to reflect
facility congestion then he will have an incentive to constrain capacity and
increase his profits from congestion pricing.

While access prices can be used to promote each of these elements of

economic efficiency, it is unlikely that any single pricing scheme will be able
to satisfy all of these requirements. A pricing scheme that allows for
productive efficiency is unlikely to promote efficient investment. A scheme
that ensures efficient investment over time will generally reduce allocative
efficiency. Access pricing will either require a trade off between these
different elements of economic efficiency or additional regulatory tools
designed to overcome deficiencies in the pricing rules.

Economic efficiency should be one goal of access pricing. However, it may

not be the only goal. Section 44X.1.b of the Trade Practices Act 1974
requires the ACCC to consider "the public interest, including the public
interest in having competition in markets" when making a determination of an
access dispute. The Commission may also have regard to this matter in
deciding whether to accept an access undertaking (s.44ZZA.3.b). These
sections suggest that the public interest should be interpreted more broadly
than economic efficiency. Such an interpretation would be in line with the
discussion in the Hilmer report, which notes that notes the importance of
"other social goals" such as "empowerment of consumers".11

The Industry Commission notes that "[c]onsistency in approach suggests that

the NCC and the ACCC should be required to give priority to efficiency in
resource allocation in their deliberations".12 While this conclusion is subject to
some debate, for the purpose of this paper, we will use the three forms of
economic efficiency as a base to compare different access price regimes.

II. ACCESS PRICING: EFFICIENCY AND COMPROMISE

A. PRICING AND ALLOCATIVE EFFICIENCY

A simple economic principle underlies access pricing that promotes allocative

efficiency. In the absence of any offsetting effects, the optimal price is set
equal to the short-run marginal cost (SRMC) of production for the last unit
sold.13

The SRMC of production is the extra cost associated with a one unit increase
in output. For example, if a firm needs to increase its use of labour by one
hour at a wage of $50 per hour and needs to buy additional raw materials at a
cost of $100 to produce an extra unit of output, then the SRMC of that extra
unit is simply the total cost of the additional inputs, $150. If production
occurs in a factory that is already rented by the firm on an annual contract then
the SRMC would not include any part of that rent. The rent is a fixed cost for
the firm in the short-run. The SRMC only includes those costs directly
associated with the additional unit of output.

SRMC is based on economic costs rather than accounting costs. For example,
consider that in addition to an extra hour of labour and the additional raw
materials, a one unit the increase in production requires the use of a machine
which otherwise could be used to produce an alternative product. Then any
(economic) profits that would have accrued from producing that alternative
product represent an opportunity cost to the firm. Such opportunity costs need
to be included in SRMC.14 Similarly, if the firm increases its production and
this leads to a social loss that is not borne by the firm, this loss should be
considered part of SRMC. An example is the social cost of pollution.

If the relevant production facility is capacity constrained, so that no extra

output can be produced in the short-run, then the SRMC is adjusted to allow
for congestion. In this situation, efficient pricing involves rationing the
infrastructure service on the basis of price.
SRMC pricing promotes allocative efficiency because it sends the correct
economic signals to anyone wishing to obtain the relevant good or service.
From an economic perspective, we would only want an extra unit to be
produced and sold if the value to the person purchasing that unit is at least as
great as the cost of providing that unit. If price was below SRMC there would
be excessive demand for the product. If the producer were to meet this
demand, then some consumers would purchase the good despite the marginal
cost of production being greater than their personal value. Such consumption
would be socially wasteful.

It is also undesirable to set the price so that a potential purchaser who does
value the output at more than the marginal cost of production is dissuaded
from buying the product. Such a failure to purchase would lead to a social
loss as the cost of providing the product is less than its value to the purchaser
and yet the product has not been provided. The optimal regime involves price
equal to SRMC.

While SRMC pricing maximises allocative efficiency, it presents two practical

problems which impinge on productive efficiency and incentives for efficient
investment. First, if the regulator requires access to be offered at short run
marginal cost, then the facility owner may have little incentive to reduce this
cost. Any effort taken by the owner that improves productive efficiency by
lowering SRMC is transferred into lower access prices. While time lags
between the realisation of cost savings and the adjustment of access prices by
the regulator may provide the facility owner with some temporary return from
improved productive efficiency, the owner is unlikely to face the optimal
incentives to engage in cost minimising activities.15

Secondly, access services that are produced using large infrastructure facilities
such as transmission grids, rail systems or networks of pipelines, often involve
significant returns to scale. Average production costs tend to fall for these
facilities as output rises until the facility becomes congested, and short run
marginal costs are generally less than average production costs. SRMC
pricing does not allow the facility owner to cover his costs unless the facility
is so congested that the congestion rents under SRMC pricing are able to
cover the owner's average costs. A facility owner who believes that he will be
forced to price access at SRMC will either refuse to build a facility or will so
restrict the capacity of the facility that the congestion rents will allow him to
make at least an adequate return on his investment. Neither situation is likely
to be economically optimal.

B. IMPROVING ON SRMC PRICING

1. Non-linear pricing

While SRMC pricing requires that the marginal price for access is set equal to
SRMC, it does not require that the infra marginal price is also set equal to
SRMC. By allowing a facility owner to use non-linear pricing schemes it is
possible for him to generate a reasonable return on his investment without
constraining capacity in an undesirable way.

A two-part tariff, which involves an upfront fee and a per unit price, is the
simplest form of non-linear pricing scheme. By setting the per unit price
equal to SRMC, a two-part tariff retains allocative efficiency. At the same
time, the upfront fee can be used to cover the costs of infrastructure
development. Freebairn and Trace16 recommend a two-part tariff for pricing
railway services to coal producers. "The first-part tariff ... would cover each
mine's allocation of unattributable costs as well as the capital costs of
dedicated infrastructure. ... The second-part tariff would be a per tonne of
product charge based on marginal costs".

When setting the upfront part of a two-part tariff, it may be desirable to allow
the access provider to discriminate between access purchasers. Setting a
uniform upfront fee, say, at a simple average of facility development costs,
may exclude some low value users from purchasing access even though these
consumers have a marginal willingness to pay that exceeds SRMC. Allowing
the access provider to set a lower upfront fee for these users, but a larger fee
for higher value access seekers will promote efficient facility use.

Price discrimination will only be possible if resale between access seekers can
be prevented. Also, both efficiency and equity considerations will require a
limit to be placed on the profits the access provider can make from the upfront
fees. Without such a constraint, the access provider will have an incentive to
raise upfront fees. This will provide him with two benefits. Raising the fee
will limit the degree of downstream competition by creating a barrier to entry
for new firms. The high fee will also enable the access provider to reap most
of the profits that are created by restricting downstream competition.

While two-part tariffs are the simplest form of non-linear prices, it is possible
to design far more complex tariffs. Common examples include "block tariffs"
and quantity discounts.17

2. Rate of return regulation

The use of non-linear tariffs can allow the infrastructure owner to gain a
reasonable return on his investment. However, it may be difficult for the
regulator to judge whether the prices set by a facility owner represent a
reasonable return or abuse of market power. To the degree that the facility
owner is able to reap monopoly profits through a non-linear access pricing
scheme, and in so doing distort final product competition and prices, the
regulator will want to control those profits. A traditional approach to this
problem involves valuing the infrastructure owner's capital stock to form a
'rate base' and allowing him to set access prices that generate no more than a
regulated return on this base. This regulation, which has been used
extensively in the United States for more than a century, is called rate-of-
return (ROR) regulation.

While ROR regulation is often linked with uniform pricing (above SRMC)
this need not occur. Given the allowed return on his rate base, the facility
owner should be encouraged to set prices that lead to optimal facility use.

However, ROR regulation presents other problems. Like other regulations

which limit the facility owner's profits, ROR regulation reduces the incentives
for the owner to minimise production costs. In fact, ROR regulation creates
incentives for the access provider to deliberately choose an inefficient mix of
productive inputs. If the access provider expands his capital inputs then this
will increase his rate base and raise allowed profits. Consequently, ROR
regulation tends to be associated with over capitalisation and over investment
in infrastructure facilities.18 While solving the problem of allowing the owner
to receive a reasonable return on his investment, ROR regulation can
exacerbate productive distortions.

3. Price cap and incentive regulation

Price cap regulation is a commonly used alternative to rate-of-return

regulation. Unlike ROR regulation, price caps are designed to promote
productive efficiency. The regulator sets a maximum price that the facility
owner can charge for, say, the next five years. The facility owner can then
retain all of the extra profits that he can make by reducing operating costs over
that five year period until the price caps are reviewed by the regulator. The
price caps can be adjusted for inflation and for expected future cost savings
when they are reviewed. As a result, price cap regulation is often called RPI-
X regulation in the UK or CPI-X regulation in Australia. The caps are
automatically adjusted for the inflation rate as measured by the retail price
index (RPI) or the consumer price index (CPI) together with a reduction
reflecting expected future cost savings (X). Price cap regulation has been
widely used in telecommunications, to regulate BT in the UK, AT&T in the
US, and Telstra in Australia.19

RPI-X and CPI-X regulation can be problematic. For a multi-product firm,

such as a telecommunications company, the price cap will apply to baskets of
goods. The firm will retain some ability to rebalance prices within a basket.
Such rebalancing need not be economically efficient or politically desirable.
For example, when initially regulated by an RPI-3 rule, BT quickly rebalanced
its prices to raise local call charges and drop long distance rates. These price
changes enabled BT to aggressively fight the entry of Mercury
Communications Ltd in the long distance call market while raising profits
through high prices in its monopoly areas.20

Reviewing the value of X has also led to a blurred distinction between price
caps and ROR regulation. The resetting of X has depended on the realised
profits of the regulated firm. Consequently, as the review process approaches,
the firm has similar incentives to distort its costs as under other forms of
regulation. Further, even though price cap regulation is meant to involve fixed
periods between reviews, in practice regulatory intervention has been
forthcoming between reviews when observed profits appear too high.

In practice, price cap regulation and ROR regulation appear to have similar
consequences. However, this similarity is due to inappropriate reliance on
historic costs and profits in reviewing the value of X. A review process based
on comparisons between access providers in different markets or even
different countries, which also uses other data that is not specific to the
regulated firm, may offer significant advantages.21 Whether such a procedure
can be practically implemented remains to be seen.

4. Efficient components pricing rule

Efficient components pricing (ECPR) is a regulatory rule designed to promote

productive efficiency among access seekers when there is a vertically
integrated access provider. It involves a two-part regulatory process. First,
final product prices are restrained by a price cap. Given this cap, the facility
owner can sell access at a price that not only recoups his production costs, but
also compensates him for any foregone profits from final product sales due to
the additional competition from access seekers. ECPR has been strongly
advocated by Baumol and Sidak for electricity and local telephone access in
the US.22 The recent case between Clear Communications and Telecom New
Zealand centred around ECPR (called the Baumol-Willig rule in this case). In
particular, the case examined whether Telecom New Zealand's offer to provide
local interconnection to Clear on the basis of ECPR was a violation of s36 of
the New Zealand Commerce Act, when there were no final market price
controls in place.

The logic behind ECPR is both simple and, in the correct context, compelling.
As an example,23 consider that the marginal cost of access is $3 per unit of the
final good and the other marginal costs of providing a unit of the final good
are $5. Let the price of the final good be constrained by a price cap at $10. A
facility owner who is vertically integrated and operates as a final market
monopolist would make variable profits of $2 per unit from final goods sales.
Assume that if the facility owner provides a unit of access to a competitor in
the final market then the access provider's sales in this market decline by one
for each extra unit sold by the competition. If the facility owner provides one
unit of access to a competitor who uses this access to provide one unit of the
final good, then the opportunity cost of providing this access is the marginal
cost $3 plus the foregone profits $2. Under ECPR the access charge should be
set, not at SRMC which is $3 but at opportunity cost which is $5.

Why is such pricing desirable? Consider a downstream competitor who is not

as efficient as the incumbent integrated facility owner. For example, the
competitors cost of producing the downstream product given a unit of access
might be $5.50. It would then be economically undesirable for the competitor
to enter the downstream market. Such entry would result in inefficient
production. However, the inefficient competitor could enter if access was
priced at SRMC. If the competitor paid $3 for a unit of access and paid an
additional $5.50 to produce the final product given the unit of access, then his
total cost per unit will be $8.50. This is $0.50 more than the cost for the
incumbent firm but is less than the market price of $10. The inefficient
competitor can enter and make $1.50 profit per unit. In contrast, if access
prices were set by ECPR then the total cost of production for the inefficient
competitor would be $10.50; $5 for a unit of access and $5.50 to turn this unit
into final product. The competitor could not make a profit at a final market
price of $10. Only if the competitors costs of turning access into final product
were at least as low as those of the incumbent facility owner, would the
competitor be able to profitably enter when access is priced according to
ECPR.

ECPR can promote efficient entry and production in the final goods market.24
However, this is not the same as the productive efficiency discussed above.
Rather, previous sections have discussed efficient production of access, not
efficient production by the access seekers. This omission has been quite
deliberate. If we are seeking to open final market production to competition
by requiring the facility owner to provide access, then so long as all
competitors (including the facility owner himself) can buy access at the same
price then competition should drive inefficient downstream producers out of
the market. If an access seeker is inefficient then an alternative producer
should be able to enter the final market, buy access and force out the
inefficient producer. If the access provider himself is inefficient in
downstream production then he will also be forced out of final market
production and will have to retreat to simply providing access to his essential
infrastructure services. Put simply, ECPR only does what we expect
competition to do anyway.

ECPR is a useful adjunct to downstream competition only when regulators

believe that downstream competition will be either muted or distorted. For
example, if regulators restrict final market entry to a single licensed firm, as
has occurred in telephone carriage services in Australia, then there is unlikely
to be effective final market competition. ECPR can be used in this situation to
prevent the licensed firm entering markets where it is less efficient than the
vertically integrated incumbent. However, a better solution to this problem
may be to allow unrestricted entry downstream.

Alternatively, a vertically integrated incumbent may be able to abuse its

control over access to distort downstream competition and either provide its
own subsidiary with access at a more favourable price than it offers to
competitors, or engage in cross subsidisation in order to manipulate its
regulatory regime.25 ECPR will limit these distortions. For example, it does
not pay a vertically integrated producer to protect its own inefficient
downstream subsidiary under ECPR as it is fully compensated for foregone
profits. However, a better regulatory solution may involve tackling the
distorted competition at its source by requiring the access producer to
vertically divest its downstream subsidiary.26

A third situation where ECPR can aid efficient downstream entry is if

regulated final product prices involve cross subsidies. For example, the
vertically integrated incumbent producer may be required to cross subsidise
rural consumers by charging a higher price to urban consumers. If the
downstream market is opened to competition with access sold at SRMC, then
new entrants will only sell to profitable market segments. New entrants will
be able to undercut the incumbent in the urban market as they do not need to
cross subsidise rural consumers. To protect the incumbent and maintain the
cross subsidy, access can be priced by ECPR so that new competitors in the
urban market compensate the incumbent for any foregone profits through the
access price. However, a better regulatory solution may involve either
removing the cross subsidies from the final product prices or removing the
facility owner’s burden to finance these subsidies.

ECPR is most useful when political constraints prevent the introduction of fair
competition in the downstream market. However, in the absence of such
concerns, ECPR is equivalent to a final market price cap regime, with
unregulated uniform access prices. The incentives for productive efficiency in
the provision of access under a final market price cap will be similar to those
that arise when access prices are directly capped. As discussed above, to the
degree that future price caps are set according to current profits, price cap
regulation will provide distorted productive incentives, similar to ROR
regulation. Also, if the price caps are set too high, then there will be a loss of
allocative efficiency. ECPR does not address either of these issues.

If ECPR is used without final market price caps then the rule is the same as
allowing unconstrained monopoly pricing of access. This has been recognised
by the proponents of ECPR.27 However, the problem is not the access pricing
rule but rather that ECPR is really a two-stage process. It is only designed to
work with final market price controls in place.

The access pricing rule under ECPR is not designed to promote either
allocative efficiency, efficient access production or efficient investment
decisions over time. Rather, these issues are handled by final market price
constraints under ECPR. The access pricing rule is designed solely to promote
efficient entry in the downstream market in circumstances when other
distortions exist that would impede such entry and those distortions cannot be
removed for either economic or political reasons. Because of its limited
applicability, ECPR is unlikely to play a major role in Australian
infrastructure access.
C. EFFICIENT INVESTMENT AND LONG-RUN MARGINAL COST
PRICING

Using non-linear tariffs, together with SRMC pricing, can promote allocative
efficiency and least cost downstream production while allowing facility
owners to earn a reasonable return on their investments. Utilising price caps
may also promote efficient production decisions. Even so, such schemes are
unlikely to promote efficient investment.

Long run marginal cost (LRMC) is the cost of increasing output by one unit
when both the variable costs of production and the costs of expanding the
relevant facility are taken into account. Unlike SRMC, which ignores any
input costs that cannot be adjusted in the short-term (for example, production
capacity that is already rented on an annual contract), LRMC considers the
cost of production when all inputs can be varied. Because it can allow for an
optimal plant capacity, LRMC will be below SRMC whenever existing
production facilities are operating above their optimal capacity. However, if
existing facilities are operating below optimal capacity, LRMC will exceed
SRMC.28

If demand for access grows steadily over time, then requiring a facility owner
to price access at LRMC can induce efficient investment without any loss of
allocative efficiency. Under LRMC pricing, capacity will adjust to the
economically optimal level while simultaneously setting the access price equal
to the congested adjusted SRMC.

Unfortunately, if demand for access is more complicated; involving for

example periods of peak and off-peak use, a variety of different peak periods
say over a daily cycle, or varying around a trend rate of growth; then simple
LRMC pricing will promote neither allocative efficiency nor optimal
investment. If there are multiple peak periods using the same access
facilities, then economically optimal investment requires expanding the
facility until the total value of an extra unit of capacity to all peak users is
equal to LRMC. Pricing to promote efficient investment would require that
the sum of all peak period prices equals long run marginal cost. Setting price
at LRMC to all users would substantially overprice access and lead to under
investment. If there are both peak and off-peak users, then LRMC pricing will
lead to allocative inefficiency in off-peak periods. Peak period users will have
too little incentive to substitute to off-peak and off-peak users will tend to
purchase too little access. Finally, if there is a single (peak period) demand
that is volatile, LRMC pricing will require non-price rationing when demand
is unexpectedly high and will overprice access when demand is unexpectedly
low.

LRMC pricing is most likely to be useful where there is a single, well-defined

peak period for access demand. In such a circumstance efficient investment is
encouraged by requiring the access provider to sell reserved capacity during
the peak period at long run marginal cost and to expand capacity whenever
demand in the peak period cannot be met at this price. SRMC pricing can be
used in off-peak periods, and upfront tariffs can recover any costs associated
with initial construction that are not covered by LRMC pricing.

These situations are likely to be rare in practice. In energy industries, peak

use is often related to weather and cannot be predicted in advance. In water
industries, new infrastructure involves lumpy investments so that LRMC is not
well defined. In urban rail systems, there are usually multiple peaks in both
the morning and the evening rush hours. While LRMC tariffs may provide a
useful basis for access pricing in some industries, these cases will be the
exception rather than the norm.

D. ACCESS PRICING AND ASYMMETRIC INFORMATION

Access pricing inevitably involves information asymmetry between the access

provider, the access seekers and the relevant regulatory authorities.
Regulators will be unable to perfectly value the assets used to provide access.
Short run and long run cost information will not be easily available and the
access providers who are most likely to know relevant cost figures will often
have little incentive to correctly provide this information to regulators.

Sensible access pricing procedures recognise this information asymmetry. For

example, price cap regulation is based on the premise that the regulator will
not be able to perfectly monitor cost reducing activities by the access provider.
By allowing the access provider to retain any benefits from such activities,
price cap regulation compromises allocative efficiency in order to maintain a
greater degree of productive efficiency.

Economic theory provides a wide range of tools designed to overcome

regulatory problems with information.29 The lessons from this literature are
relatively simple. First, regulators need to recognise that they will often be at
a disadvantage compared to access providers. There is little point requiring
access providers to set capacity according to long run marginal cost when the
only information the regulator has about those costs will be provided by the
access provider themselves. Such a request simply invites the access provider
to plead ignorance, manipulate accounting measures of cost, and pad out
LRMC measures so that any reports will provide little indication of the true
level of costs.

Secondly, efficient access pricing schemes will try to overcome asymmetric

information and recognise information constraints which are unavoidable and
minimise their effect. For example, benchmarking access against comparable
facilities in Australia or overseas can provide a powerful tool to overcome
information problems and improve incentives. Benchmark comparisons can
be used to structure price caps or revenue caps for the access provider.
Because these caps depend less on the access provider's own costs and more
on the costs of related businesses, the facility owner has greater incentives to
operate efficiently and less incentive to distort reported costs.

Similarly, where a number of participants in the market place may have

relevant cost information, then the regulator can use competition between
these participants to reveal information. Franchise auctions are a simple
example of a regulatory scheme designed to elicit information from multiple
providers.30 Regulators can also use information provided by access seekers to
control access prices. This information can be indirectly used by requiring the
access provider to separately price each access service and then allowing
facility bypass. An example in local telephone access would require the
access provider to separately price switching, switch-to-customer access, and
switch-to-point-of-interconnection access, allowing long distance telephone
companies that purchase access to bypass any of these three components if
they believe it is overpriced. Alternatively, regulators can directly use access
seeker cost information, realising that access seekers may also have incentives
to distort regulatory reports.

Thirdly, practical access prices will involve compromise. It is usually

impractical to try and design an access pricing scheme that satisfies all the
requirements of economic efficiency. A desirable access pricing regime will
trade off distortions, weighing each by its potential long term detriment to
welfare. Thus, a regulator may be quite satisfied with a price cap scheme that
leads to overpricing in the short term if this loss is more than outweighed by
long term productivity improvements. Similarly, it may be desirable to allow
an access provider significant profits through the upfront component of a
nonlinear pricing scheme if this leads to improved investment incentives. An
important trade off involves administrative simplicity and regulatory
complexity. While such compromises are unlikely to satisfy access providers,
access seekers or final product consumers, maintaining a balance of
incentives, information requirements and simplicity is most likely to provide
economic benefits.

III. NEGOTIATED ACCESS

While the ACCC will be able to influence access prices through its role in
judging access undertakings and making determinations for access disputes,
the main thrust of both the Hilmer report recommendations and Part IIIA of
the Trade Practices Act 1974 is to provide negotiated access. The parties to
access negotiations, however, will be more interested in profits than economic
efficiency. This may lead to negotiated access prices that differ substantially
from the principles outlined above.

There will be circumstances where profit maximising access prices and

efficiency coincide. This will occur for example if the access seekers use the
services as an input to a product for which they have little market power or
which is fully exported. A railway line, such as the Hunter Valley Railway
Project, which is used to transport coal for export, illustrates this point. Given
the world price for coal, the coal producers and the rail authorities both have
an incentive to operate the line efficiently. All parties will find a scheme of
nonlinear prices based on congestion adjusted SRMC desirable compared to
other alternatives. While the rail authority and the miners will dispute parts of
the pricing scheme, such as any upfront fees, such disputes represent a "cake
splitting" problem. Each party wants a bigger slice of the 'cake' but no-one
benefits by choosing inefficient access prices that make the 'cake' smaller.

However, this coincidence of economic efficiency and profit maximisation

will be rare. If there are monopoly rents to be gained from the relevant final
product markets, then the access seekers and access provider will want to
construct access prices that prevent these rents from being diluted by
competition. Negotiating parties will have an incentive to set access prices
that sustain high final product prices while simultaneously sharing the
monopoly profits. For example, if there are few access seekers and final
market competition will be weak, then it will pay all parties to set a low
marginal price for access (possibly even below SRMC) and use upfront fees to
divide final market profits between the access seekers and access provider.
Conversely, if final market competition is likely to be strong, it will pay all
parties to establish a relatively high marginal access price and to use, say,
rising block tariffs to divide any profits.31

The disappointing (but rather obvious) conclusion is that negotiating parties

will have strong incentives to agree on access prices that promote monopoly
profits rather than economic efficiency. It may not be possible for all parties
to perfectly coordinate on profit maximising prices.32 Disagreement may be
encouraged by the ACCC. For example, if the ACCC treats initial access
complainants more favourably than other access seekers in any subsequent
determination then this would undermine access price agreements that sustain
and divide monopoly profits. Encouraging access undertakings may also
prevent undesirable negotiated access prices. However, to the degree that
access disputes are resolved through negotiation without regulatory
intervention or oversight, there are strong incentives for both access seekers
and facility owners to construct prices that protect profits.

IV. CONCLUSION
Access pricing presents a complex regulatory problem. There are no simple
rules for pricing access which maximise allocative and productive efficiency
and provide desirable investment incentives except in fairly limited
circumstances. Even when such rules could be applied in theory, problems of
implementation will usually mean that they cannot be used perfectly in
practice.

A sensible approach to access pricing recognises these limitations and

develops a set of rules which trade-off various theoretical and practical
concerns. These rules will often be industry specific. Optimal access prices
will depend on market circumstances, such as the volatility of demand and the
ability to use competitive tools to overcome information constraints. There
may be some industries where short run marginal costs are easily calculated
and non-linear tariffs using SRMC pricing can be swiftly implemented. In
other circumstances, creating spot markets for access together with regulatory
oversight of infrastructure investment, may lead to desirable incentives.

Access pricing will involve a variety of trade-offs. There are, however, some
broad principles that will often apply. Non-linear pricing schemes will usually
be preferred to uniform pricing schemes. Congestion adjusted SRMC pricing
will promote allocative efficiency. Constraining any congestion rents under
SRMC pricing to not exceed long run marginal costs may help improve
investment incentives. Transforming relevant constraints into price or revenue
caps may aid productive efficiency. Using relative performance comparisons
and reducing either explicit or implicit reliance on rate-of-return type
procedures will also aid incentives for efficient production.

Where access prices are set by negotiation between access seekers and the
facility owner, there will be strong incentives for the negotiating parties to
agree on prices that maintain and divide downstream monopoly profits. In
some limited cases this will provide few concerns. But in general, negotiated
infrastructure access may lead to few if any gains compared with integrated
monopoly.

Access pricing will involve compromise. It is important for regulators to

recognise their information constraints and to work to limit the problems
created by these constraints. It is also important to recognise the costs of
regulation and the need for simple, workable solutions to access pricing
problems. While there is not a 'one size fits all' solution, there is scope for
innovative approaches which recognise the needs and incentives of all parties.

1
See The Commonwealth of Australia (1993) National Competition
Policy: Report of the Independent Committee of Inquiry, (The Hilmer Report),
AGPS, Canberra, especially chapter 11.
2
For a general discussion on these type of production processes, see S.
King and R. Maddock (1996) Unlocking the Infrastructure, Allen and Unwin,
St Leonards, particularly chapter 5, or M. Waterson (1987) "Recent
developments in the theory of natural monopoly", Journal of Economic
Surveys, 1, 59-80.
3
For a discussion of the potential for a separate gas market within the
context of s50 of the Trade Practices Act 1974, see R. Smith (1995) "The
practical problem of market definition revisited", Australian Business Law
Review, 23, 52-60. For a discussion of market definition for access purposes,
see S. King and A. Marshall (1996) Market definition and competition policy:
the case of access, Mimeo, ANU.
4
In the United States, these two separate elements are (weakly) reflected
in the 'essential facilities doctrine'. The elements required to apply the
doctrine include monopoly control of an essential facility, the inability of a
competitor to practically or reasonably duplicate the facility, and the denial of
use of the facility to a competitor. Essentiality has been interpreted by the
courts as requiring that it is economically infeasible to duplicate the facility
and that denial of access would severely handicap new market entrants. See P.
Cook (1994) "Essential facilities - does it have a place in Australian
competition law?", Australian and New Zealand Trade Practices Law
Bulletin, 10, 36-37 at 36.
5
Essential facility problems have previously been dealt with in
Australia through industry specific legislation or through s46 of the Trade
Practices Act. Queensland Wire Industries Pty Ltd v BHP Co Ltd (1989),
ATPR, 40-925 and Pont Data Australia Pty. Ltd. v ASX Operations Pty. Ltd. &
Anor (1990), ATPR, 41-007 are two examples of s46 cases involving access
issues. The Hilmer report did not consider either of these approaches to be
adequate. In particular, the report considered that the requirement under s.46
to prove a "proscribed purpose" was problematic (supra n1., p.243). The
Hilmer Report was also concerned with the desirability of requiring the courts
to determine "the terms and conditions, particularly the price, at which access
should occur" (supra n1, p.243). The report recommended the establishment of
an alternative administered regime.
6
For a general discussion on issues relating to vertical relationships
between firms see J. Tirole (1988) The Theory of Industrial Organisation,
MIT Press, Cambridge MA. For a discussion in the Australian context, see S.
King and R. Maddock (1996) supra n.2.
7
See chapter six of the National Grid Management Council (1996)
National Electricity Market Code, Draft version 1.0.
8
For example see Australian Competition and Consumer Commission
(1996) National Electricity market Code of Conduct: Comments and Issues
Arising, mimeo, Canberra and S. King (1996) Infrastructure Access: the case
of electricity in Australia, Paper presented to the 1996 Industry Economics
Conference, ANU, July..
9
Of course, if the facility owner is vertically integrated into the
downstream market, constraining prices by itself will not solve the access
problem. The facility owner will have an incentive to deny or avoid providing
access to its competitors. This raises a number of issues, such as the ability of
a facility owner to reduce the quality of access it sells to its downstream
competitors, which are beyond the scope of this paper. In our discussion of
access pricing below, we will assume that the regulator can ensure that access
is provided to potential downstream competitors.
10
S. King (1996) Who took the competition out of national competition
policy: access pricing under rate of return regulation, mimeo, ANU, presents
an example where, once the upstream profit constraint is established, actual
access prices have no further economic implications.
11
Supra n.1 at 5.
12
(1995) Implementing the National Competition Policy: Access and
price regulation, Information Paper, Melbourne, at 64.
13
See C. Doyle and M. Maher (1992) "Common carriage and the pricing
of electricity transmission", The Energy Journal, 13, 63-94, A. Kahn (1988)
The economics of regulation, MIT Press, Cambridge MA, and M. Slater
(1989) "The rationale of marginal cost pricing" in D. Helm, J. Kay and D.
Thompson (eds) The market for energy, Clarendon, Oxford. For a list of
'offsetting effects', see S. King (1995) Access Pricing, Research paper number
3, Government Pricing Tribunal of New South Wales, Sydney.
14
While the opportunity cost of inputs is part of SRMC, the opportunity
cost of the output is not part of SRMC. For example, consider that access can
be used by the facility owner in his own downstream production or can be sold
to a downstream competitor. Then the foregone profits from own downstream
production when a unit of access is sold to a competitor are an opportunity
cost of that sale but are not a cost of producing access. This failure to
distinguish between an opportunity cost of production and an opportunity cost
from alternative disposal is incorporated in to the standard definition of the
efficient components pricing rule. See for example, W. Baumol and J. G.
Sidak (1994) Towards competition in local telephony, MIT Press, Cambridge,
MA at page 94.
15
This problem and potential regulatory solutions is examined in detail
by J. Laffont and J. Tirole (1993) A theory of procurement and regulation,
MIT Press, Cambridge, MA.
16
(1992) "Efficient railway freight rates: Australian coal", Economic
analysis and policy, 22, 23-38 at 37.
17
B. Mitchell and I. Vogelsang (1991)Telecommunications pricing:
theory and practice, CUP, Cambridge, especially chapter 5, provide a more
detailed analysis of a variety of non-linear pricing schemes.
18
This is sometimes referred to as the Averch-Johnson effect. It was first
shown formally in H. Averch and L. Johnson (1962) "Behavior of the firm
under regulatory constraint", American Economic Review, 52, 1052-1069. For
a discussion of rate-of-return regulation, see chapter 21 in D. Carlton and J.
Perloff (1994) Modern Industrial Organization, Harper Collins, New York.
19
Price caps are used slightly differently in the US to Australia and the
UK. See D. Sappington and D. Sibley (1992) "Strategic nonlinear pricing
under price-cap regulation", RAND Journal of Economics, 23, 1-19 and P.
Navarro (1995) "The ABCs of PBR", Public Utilities Fortnightly, July 15, 16-
20.
20
See J. Vickers and G. Yarrow (1988) Privatization, an economic
analysis, MIT Press, Cambridge, MA, and M. Armstrong, S. Cowan and J.
Vickers (1994) Regulatory reform; economic analysis of the British
experience, MIT Press, Cambridge, MA.
21
See M. Beesley (1996) "RPI-X: principles and their application to
gas", in M. Beesley (ed), Regulating Utilities: Time for a Change?, Institute of
Economic Affairs, London.
22
See W. Baumol and J. G. Sidak (1994) supra n.14. Also W. Baumol
and J. G. Sidak (1995) "Stranded costs", Harvard Journal of Law and Public
Policy, Summer, 837-849.
23
This example is similar to one provided in Baumol and Sidak (1994)
supra n14.
24
The example given above is very simple. In any actual market, ECPR
needs to be adjusted to retain its desirable features. For example, a unit of
competitor's product need not crowd out exactly a unit of the incumbent's
product. See M. Armstrong, C Doyle and J. Vickers (1996) "The access
pricing problem: a synthesis", Journal of Industrial Economics, 44, 131-150.
The example also assumes that the final price stays constant at $10, even if
inefficient entry occurs. In contrast, if the access price was set at $3 and the
threat of inefficient entry forced the incumbent facility owner to reduce his
final product price to $8.49 in order to prevent entry, then the threat of
(inefficient) entry would not lead to any actual inefficient production but
would benefit consumers by lowering the final product price. For a broader
discussion of this issue see N. Economides and L. White (1995) "Access and
interconnection pricing: how efficient is the efficient components pricing
rule?", Antitrust Bulletin, 40, 557-579.
25
These possibilities are discussed in T. Brennan (1987) "Why regulated
firms should be kept out of unregulated markets; understanding the divestiture
in United States v AT&T", Antitrust Bulletin, 32, 741-793.
26
For a discussion of the arguments for and against vertical divestiture,
see chapter 8 in S. King and R. Maddock (1996) supra n.2.
27
See Baumol and Sidak (1994) supra n14 at 108.
28
For a brief review of the difference between long run and short run
costs, see H. Varian (1993) Intermediate Microeconomics (3rd. ed.), Norton,
New York, especially chapter 20.
29
See D. Baron (1989) "Design of regulatory mechanisms and
institutions", chapter 24 in R. Schmalensee and R. Willig (eds) Handbook of
Industrial Organization, v2, North Holland and Laffont and Tirole supra n.15.
30
See H. Demsetz (1968) "Why regulate public utilities?", Journal of
Law and Economics, 11, 55-65 and M. Crew and M. Zapan (1991) "Franchise
bidding for public utilities revisited", chapter 10 in M. Crew (ed) Competition
and the regulation of utilities, Kluwer.
31
For a more detailed discussion of these issues see King and Maddock
(1996) supra n2.
32
For example, sequential contracting may prevent negotiating parties
from perfectly sustaining final market monopoly prices. See R. P. McAfee
and M. Schwartz (1994) "Opportunism in multilateral vertical contracting:
nondiscrimination, exclusivity and uniformity", American Economic Review,
84, 210-230. Even in the case of only a single access seeker, brinksmanship
and the incentive for the access provider to stall negotiations may lead to less
than perfect monopoly pricing. See S. King and R. Maddock (1996)
Regulation by negotiation: a strategic analysis of Part IIIA of the Trade
Practices Act, paper presented to the 14th economic theory conference,
LaTrobe University, February.