Regulation
gPolicyy and Economics of Regulation
gClass No. 8 (file 7): Essential Facility andAccess Charge

Objectives
jof Today’sy Class((1)) To understand the concept
p of an essential facilityy(2) To understand the way of thinking as to an access charge

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Outline of Class No. 7
7-1 Double Marginalization and Vertical Integration
7-2 EEssential
ti l F
Facilities
iliti
7-3 Access Pricing
7-4 Examples in JapanREGULATION POLICY & ECONOMICS OF REGULATION

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V ti l BusinessVerticalB iRelations
R l tiUpstream Firm

Downstream Firm

MarketREGULATION POLICY & ECONOMICS OF REGULATION

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Examples of Vertical Business Relations(1) Manufacturer(2) Raw materials dealer(3) Wholesaler(4) Parts manufacturer(5) Patentee(6) Brand possessor(7) Power transmission division(8) Airline, hotel(9) Production company(1010)) MNO
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Ӎ Sales company
Ӎ Final goods manufacturer
Ӎ RetailerӍ Final goods manufacturer
Ӎ Manufacturer
Ӎ Manufacturer
Ӎ Electricity selling division
Ӎ Travel agency
Ӎ Broadcasting enterpriseӍ MVNO4Substitutive Relations and Integration
Question: Suppose both Firm 1 and Firm 2 supply theclosely substitutive goods
goods, and that each firm is themonopolistic enterprise within the individual field of the good.
e Firm 1 iss incorporated
co po ated witht Firm 2:When(1) Does the joint profit increase?
(2) Does the price go up?
Provided that the merger brings about no improvement or
productivity,y, and that no pricep
regulationgdeterioration in the pexists.

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5Complementary Relations and Integration
Question: Suppose both Firm 1 and Firm 2 supply the closelycomplementary goods, and that each firm is the monopolistic
enterprise within the individual field of the good
good. When Firm
1 is incorporated with Firm 2:(1) Does the joint profit increase?
(2) Does the price go up?
Provided that the merger brings about no improvement or
deterioration in the productivity.

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Vertical Business Relations and Integration
Question: Suppose Firm 1 and Firm 2 are in vertical business
relations and that each firm is the monopolistic enterprise
relations,
within the individual field of the good. When Firm 1 isco po ated witht Firm 2:
incorporated(1) Does the joint profit increase?
(2) Does the price go up?
Provided that the merger brings about no improvement ordeterioration in the pproductivity.
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Double Marginalization
Suppose both an upstream sector and a downstream sector
are monopolistic:
If the upstream sector maximizes its profits, it ends up withsetting the price higher than its marginal cost
cost.
→Consequently, the price tends to be set at a higher point
than the one that maximizes the joint profit.
The upstream sector sells at its marginal cost to thedownstream sector .
→Consequently, the downstream firm sets its price so as tomaximize the overall profits.
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Solution to Double Marginalization(1) Vertical integration(2) T
Two-partt tariff
Twot iff ~ Basic
B i charge
h+ Variable
V i bl ffee
To set the price of the variablevariable--fee part equal to the marginal
cost and to collect the profits from the basic chargecost,charge.
Note 1: This cannot be employed where price discriminationi unusableisbl ((resalel bbeingi unavoidable).
id bl )
Note 2: This kind of contracts, if viewed as a quantity
didiscount,t exists
i t a llott more ththan it llooks.
k

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9Competition among Downstream Firms
Upstream Firm

Downstream Firm 1

Downstream Firm 2MarketREGULATION POLICY & ECONOMICS OF REGULATION

10Competition among Downstream Firms
What if thereWhhiis a competitioni i among ddownstream fifirms?
?
A variable fee to be set equal to a marginal cost
→The price ends up with the one lower than a monopolisticprice.
⇒If the downstream firms are symmetric,y, it is onlyy
necessary to increase a variable fee to the level where an
equilibrium price―
price―to be materialized as the result of acompetition among downstream firms―
firms―is equal to amonopolistic price.
~In case they are asymmetric,
asymmetric it is required for each firm tohave a different price, but which is not exactly easy to accomplish
because of the competition
plaw.
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11Competition among Downstream Firms
Upstream Firm

Downstream Firm 1

M k t1MarketREGULATION POLICY & ECONOMICS OF REGULATION

To involve an extra costof transportation

Downstream Firm 2Market 212

Exclusive Territories
Upstream Firm

Downstream Firm 1

M k t1MarketREGULATION POLICY & ECONOMICS OF REGULATION

Downstream Firm 2Market 213

Exclusive Territories
Prohibit Firm 1 from selling in Market 2 and Firm 2 in Market
1 respectively1,respectively.
→To practically restrict a competition⇒Attain monopolistic prices by setting a variable fee equal toa marginal cost.
~By means of restraining meaningless transportationtransportation, thecosts of overall corporate divisions go down.
⇒Consumer surplus increases as wellwell.
Matsumura (2003, CJE)REGULATION POLICY & ECONOMICS OF REGULATION

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Additional Merits of Vertical Integration▪Systematic stability
stability, quality preservation (?) →Class No
No. 7▪Economies of scope▪Difficult to cut and divide functions →Classes No
No. 7 and 9Demerits of Vertical Integration▪Difficult
Difficult to ensure neutrality with respect to competition▪Competition practically difficult to advance▪Possibility
Possibility of an internal mutual support▪Accounting information liable to be dubious

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Essential Facilities
Essential facilities ~ Bottleneck facilities
Facilities without which a market entry is not possible, but which anentering firm has difficulty in putting together by its own
exertions (technically and economically).
In general they are the facilities that have large economies ofscale.
lExamples:Local channel in the communication marketmarket,
Fiber--optic network,
Fiber
Transmission network in the electric power market,
Pipeline network in the city gas market,
OS, the charging of a fee, an authentication system, in theI tInternet,t respectivelyti l
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Access Regulation
Essential facilities ~ Bottleneck facilities
Facilities without which a market entry is not possible
possible, butwhich an entering firm has difficulty in putting together by
its own exertions (technically and economically).
economically)
There is no completion without opening them up.
→Open a facility to a new entrant’s
entrant s access with the condition
to make it pay the rent.
g, monopolisticpppower can be→ Without anyy regulation,exercised.
⇒To be regulated in proportion to the magnitude ofbottleneck nature.
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Various Regulations on Access Charges(1) Improvement of the dispute settlement system ~ The rent
i settled
isttl d ththroughh th
the negotiation
ti ti bbetweentth
those
concerned; the matter goes to arbitration only in breakdown.
(2) Indiscriminate regulation to the outside ~ As for the uses of thoseoutside the company, an identical fare is charged when their use
conditions are the same.
(3) Indiscriminate regulation to the inside and outside ~ To set the use
conditions same for one’s firm and other firms in the outside ← Separate
accounting of a sort(4) Provision regulation ~ When used by an outside firm, to make it publicly
announce the fare in advance(5) Establish a rate level per se based on a certain rule. A business entity isto independently decide and publicize that rule.
(6) Publicly establish a rule that settles a rate level.
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Cost--based Access Charges
Cost((1)) RateRate-ofof-returnreturn-cap
p regulation
g: Arrangeg pprofitability
y so asnot to exceed the upper limit that is set as the rate ofcapital.
→Rate of return ＞ Real cost of capital⇒
capital⇒Overinvestment→Rate of return ＜ Real cost of capital⇒
capital⇒Underinvestment
Averch--Johnson effect ~ This effect,
Avercheffect not limited to the accesschare regulation, can take place in all situations.
(2)( ) LumpLump
p-sum cost method: A fare that enables the recoveryyof the costs (including cost of capital) actually incurred. A
prescribed rule is applied to the aassessment
ssessment of equity capital (bysuch means as a use of other business entities’ data).
⇒To lose the incentive to scale back costs. ⇒Price
Price--cap regulation(Cf.
(Cf Class NoNo. 7)
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I
Incrementalt l Cost
C t Rule
R lPegg an access chargeg at the cost to be additionallyy incurred throughg theother firm’s use of a bottleneck facility.
~ Unable to recover the sunk cost accounting for the main source of costs(fixed costs) → To substantially impair an incentive for the investment

Long-range Incremental Cost Rule (LRIC)
Peg an access charge at the cost that enables the recovery of the costs
which are hypothetically assumed to incur if a bottleneck facility is
newly reconstructed.
(F t(Features))(1) Able to recover fixed costs ⇔ Incremental cost rule(2) Not the cost actually incurred (historical cost), but the one to incur ifconstructed now ~ Forward looking
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Forward Looking vs. Backward Looking
Forward looking:H
Hypotheticallyth ti ll calculate
l l t ththe costt bby using
i statestatet t -ofoff-theth -arttthetechnologies→Calculation
Cbased on simulations
Backward looking (historical looking) costs:
Calculation base on the costs actually incurred~ Close to the lumplump-sum cost method▪To recover more securely the costs actually incurred▪Unable to eliminate a possibility that the costs include asuperfluity
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Vested Interests Protection Rule (EfficientComponent Rule)
Sales price Ӎ Variable cost (which can be cut down under anassumption that a new entrant supplies) = Access charge
Profit margin of a new entrant = Just the advantage of thevariable cost
Problem:▪Securement of existing firms →Difficult for competition toresult in consumer benefits ~ Is it necessary to protect
existing business entities to that extent?

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Does an exorbitant access charge really resultin a barrier to the entry?
High access charge → Raises the costs of rivals (newentrants) →For a firm (being vertically integrated) having abottleneck facility, it is just a replacement of the cost, and nottthat
at itsts marginala g a cost iss ono thet e increase.
c ease⇒Which puts the competitive condition disadvantageous tonew entrants, making
g their entries difficult.
There is no guarantee that an access charge indiscriminate
to the inside and outside is always competitively neutral.
Under a complete vertical separation, competitive conditions
are identical and not disadvantageous to new entrants.
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Does an exorbitant access charge really resultin a barrier to the entry?
High access charge → Able to make enough profits with thecharge even if the rivals (new entrants) steal customers awayaway.
→ A small incentive to steal back rivals’ customers by reducing thecharge.
charge⇒As a consequence, it’s easier to make a new entry. (The entryentrybarrier effect said in the previous sheet gets cancelled in partpart.))Irrespective of complaints from existing business entities (holdersof essential facilities)) or new entrants,, the publicpinstitution oughtgto keep watch over exorbitant access charges. ← Provided that
this story is appropriate only for a price competition model.
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Ex Post Facto Adjustment of Access Charge
Cost-based access charge: A fare level whereby the [cost +Costnormal returns] can be recovered based on the projectionof the demand
Shortfall in the recovery if the demand falls short of theexpectation (the most recent FTTH), and excess returns
when it tops the projection (the latest electric power andgas) →The supply side takes on a risk of demand fluctuation.
Ex post facto adjustment:
adjustment: An adjustment system where an access charge getsraised when the demand falls short of the projection, and the one gets lowered
if the demand exceeds the expectation→expectation→Newly adopted in thetelecommunications market

Question: Comparing a case with an ex post facto adjustment (avariable access charge being pegged after a quantity competition)
against the one without it (a variable access charge being set up inadvance, thereafter a quantity competition being carried out), what
are differences in behaviors of verticallyvertically-integrated existingbusiness entities and new entrants?
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25CompetitionpEffect of Ex Post FactoAdjustment of Access Charge
Assume the cost of an essential facility constant at F regardless of the usage
volume.
Assume the usage volume of an existing business entity (being verticallyintegrated) as YI, and that of a newly entering business entity at YN.
No ex post facto adjustment: f = F/(YIE + YNE) ~ E being an expected usage
volumeEach firm, given the access charge, independently sets up YI, YN (quantitycompetition). → The equilibrium is a situation where YI and YN to be
selected in the end tally square with YIE and YNE.
With ex post facto adjustment: f = F/(YI + YN)
An access charge depends on each firm’s actual usage volume; based on theunderstanding of this relationship, each firm independently sets up YI andYN.
Question: By switching the condition of an ex post facto adjustment from its“absence” to “presence”, how do you think an equilibrium production
quantity between the existing firm and the new entrant would change?
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Reciprocal AccessTo connect two networks
EE.g.,
a statet t whereha callll can b
be maded ffrom a cellphonell hoffFirm A to that of Firm B▪For the firms
findividually owning a bottleneck facility
ftomutually open up facilities for each other▪Same function as standardization

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Examples of Reciprocal Access▪ Reciprocal access of fixedfixed-line phone business entities▪ Reciprocal access of IP telephone networks▪ ReciprocalR il access b
betweentcellphonell hbbusinessientities
titi▪ Reciprocal access between cellphones and fixedfixed-line phones▪ Reciprocal access of transmission networks and gas pipelines
Access regulation regarding reciprocal accesses▪ Access regulation similar to one for essential facilities▪ Indiscriminate regulation▪ Access bargaining based on free negotiations ← Does thisregulation
gwork pproperly?
p y
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Barrier to Entry by Access Charge
Firm A, having already taken in a large subscriber, set up an
exorbitant access charge by mutual consent with Firm B that
aimed at a new entry, and passed the jump on to the callcchargea ge foro B. (a(an aartificialt c a ccreation
eat o oof networket o externalities)e te a t es)→ No one intends to subscribe to Firm B.
→ Able to prevent the entry efficiently

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Access Charge among Business Entities
beyond Certain Scale
Firm A and B set up a reciprocal access charge by mutual consent →Unless there is an extreme difference in subscribers’
subscribers receipt of messages,
the access charge gets cancelled by and large. →Even if left to freenegotiations, nothing out of the ordinary happens (bill and keep). But an
inopportune charge distorts business strategy
strategy, nonethelessnonetheless.
▪Lower an access charge → A strong incentive to lower a variable fee
E.g. Because of the access charge, there is no competition over theintroduction of the flatflat-rate service. ~To hold back overburdening thenetwork▪Raise an access charge → Receipt of messages in excess (an incentivefor a firm to let other firms’ users utilize its network)
E.g.,
E g Softbank’s
Softbank s strategy
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