COMMON COSTS AND CROSS‐SUBSIDIES: MISESTIMATION VERSUS MISALLOCATION

1. INTRODUCTION Within the regulatory arena, cross-subsidization has emerged as a powerful tool for aiding or punishing particular groups. (1) Such cross-subsidies may be explicit. (2) More often, however, they are implicit and are thought to be implemented by means of misallocations of multiproduct, regulated firms' common costs. Indeed, significant public resources have been spent by regulators in infrastructure industries around the world to ensure that common costs for regulated; utilities are properly allocated in order to prevent cross-subsidization. (3) Accordingly, economists have studied the potential for inapt cost allocations to create cross-subsidies in a variety of settings, for example, between business and residential telephone service and long distance and local telephone service. (4) More generally, several studies have carefully documented both the ability of firms lo enhance their competitive positions via strategic cost allocations and the economic inefficiencies that may be caused by such allocations. (5) In this paper, we argue that while economists' locus on such strategic cost allocations has appropriately highlighted the potential for economically meaningful distortions to economic activity, it has, to this point, overlooked a potentially powerful role that misestimation (not merely misallocation) of common costs plays in (he creation of regulatory cross-subsidization. Indeed, under circumstances that we identify in Section III. misestimation of these costs is a necessary prerequisite to (he establishment of cross-subsidies. Moreover, while existing theories of regulatory cross-subsidization focus on the need for regulated firms to (at least partially) dupe regulators, a more complete picture that incorporates considerations from the economic theory of regulation suggests a more complicitous role for regulators. That theory alone, however, fails to illustrate the most likely means for accomplishing a desired cross-subsidy. Thus, our analysis here seeks to bring together observations on the relationship between common costs and cross-subsidization and elements of the economic theory of regulation to propose a novel, and, we believe, likely path to the creation of cross-subsidies in regulated industries. Importantly, this path is distinct from earlier contributions that have identified either distorted investment decisions or simple misallocations of (correctly estimated) common costs as the primary avenues for the achievement of cross-subsidization. The paper proceeds as follows. Section II frames the issue of cross-subsidization by examining the relevant literature on this subject. Section III, then, turns to the development of our principal results that provide for an improved understanding of the relationship between common costs and cross-subsidization. Finally, Section IV concludes. II. THE ECONOMICS OF CROSS-SUBSIDIZATION Both the economic theory of regulation and an abundance of empirical evidence suggest that one of the most ubiquitous characteristics of regulation is the creation of cross-subsidies between the various interest groups that purchase the regulated firm's products. (6) While concerns over such subsidies in regulator hearings have a long lineage, Faulhaber's (1975) seminal research was the first to carefully define prices that did, and did not, constitute cross-subsidization in the presence of an assumed natural monopoly. (7) In that context, prices are said to be subsidy free when they lead to cooperative participation by every combination of all distinct customer groups. (8) Such prices are bounded on the lower end by average incremental cost and on the upper end by per-unit stand-alone costs. With Faulhaber's concept of cross-subsidy in hand, scholars turned to examine how firms may engage in the practice to distort competition or create a more favorable regulatory environment. For example, Baseman (1981) examines whether subsidy-free prices are pro-competitive in the sense that they prohibit a firm with a monopoly in one market from excluding more efficient rivals in a second, prospectively competitive market. …