Ramsey regulation, in the context of tariff rebalancing, is analyzed when the regulator is not fully informed about the cost structure of the firm. It is shown that even if the estimated relation between variable costs of the two goods produced is correct, errors regarding the composition of a given total cost between fixed and variable elements result in: (i) the price of the good with a higher (lower) elasticity of demand decreases (increases) as the estimated fixed cost is higher; and (ii) whatever mistake is made, i.e., under or over estimating fixed costs, the profits obtained by the regulated firm are lower than intended.

Santiago Urbiztondo

English

Research Papers in Economics

www.depeco.econo.unlp.edu.ar
Confusing Fixed and Variable Costs under Ramsey Regulation
Santiago Urbiztondo
Documento de Trabajo Nro. 3
Octubre 1997CONFUSING FIXED AND VARIABLE COSTS
UNDER RAMSEY REGULATION
Santiago Urbiztondo
Professor of Economics, Universidad  National  de La Plata, and
Visiting Researcher, Fundaci6n  de Investigaciones Econtjmicas
Latinoamericanas, Argentina.
Address: Av. C6rdoba 637, 4to. piso, (1054) Buenos Aires,
Argentina
Tel.: (541)314-1990; FAX:(541)314-8648;
e-mail: santiago@fiel.org.arAbstract:  Ramsey regulation, in the context of tariff rebalancing,
is analyzed when the regulator is not fully informed about the cost
structure of the firm. It is shown that even if the estimated
relation between variable costs of the two goods produced is
correct, errors regarding the composition of a given total cost
between fixed and variable elements result in:  (i) the price of the
good with a higher (lower) elasticity of demand decreases
(increases) as the estimated fixed cost is higher; and (ii)
whatever mistake is made, i.e., under or over estimating fixed
costs, the profits obtained by the regulated firm are lower than
intended.
1. Introduction.
This paper presents briefly the problem that comes out when the
composition of the total cost of a regulated multiproduct
monopolist is unknown to the regulator in the context of tariff
rebalancing. The structure of prices is chosen by the regulator to
recover total cost minimizing welfare losses from marginal cost
pricing, i.e., according to Ramsey pricing princip1es.l  Unlike
other forms of asymmetric information, which allow the regulated
firm to obtain informational rents so discussed in the literature,'
the disinformation of the regulator under Ramsey pricing could
become a source of losses to the firm. Furthermore, as long as the
demand functions for the various goods display different price-
elasticities at equilibrium, the structure of prices that the
regulator imposes upon the regulated firm differ under various
alternative estimations of the composition of the observed total
1 The assumption underlying is that there are dynamic aspects
(such as predatory pricing) that make it unadvisable to delegate
the determination of the structure to the firm under a zero-profit
constraint, as  prices chosen would not be Ramsey in this case.
' For a recent and comprehensive treatment of regulation under
asymmetric information see Laffont and Tirole (1993).
cl>cost between fixed and variable components, even when the variable
costs of the different products remain proportional in the
different options. This question is particularly relevant in tariff
rebalancing in telecommunications, for instance, where different
estimations calculate fixed costs ranging from  20-30% (Burns
(1994)) to 80% (Oftel (1993)),3 and where current discussion exists
regarding the inappropriateness of considering access costs as
common costs (see Kahn y Shew (1987), and more recently Kaserman
and Mayo (19941, Parsons (1994) and Gabel (1995)),  each of them
thus indicating very different price structures and possible losses
to the regulated firm.
The paper is organized as follows. Section 2 presents the model.
Section 3 presents a few numerical examples that illustrate the
main results. Formal proofs are given in section 4, whereas section
5 closes with some comments.
2. The model.
Consider a benevolent regulator who, dealing with a two-products
monopolistic firm, sets prices to maximize social welfare, defined
as net consumer surplus, subject to the constraint of recovering a
fixed cost  cy through linear prices. Assume for simplicity that both
demands and costs are linear, and that they are also independent
3 In the case of Oftel  (19931, the figure corresponds to
common or joint costs. However, as the allocation of common costs
is necessarily arbitrary, they might be considered to be fixed as
well, and they are indeed so regarding each service individually.
c2>(up to the joint fixed cost in the last case). The problem then is
the following:
+ X[PJqJ  q1+P,(q,)  g,-c,q,-c,q,-4
where
91
‘(qi)  = Pi (Si) dqi, for  i=1,2
represents the (gross) consumer surplus and X is the Lagrange
multiplier.
Letting  Pi(q,)=ai-biqi, for i=1,2, the first-order conditions that
characterize the solution of this problem are the following:
=q, = b,q,  + X [a,-2b,q,-c,]  = 0,
=a =  b,q,  + X [a,-2b2q2-c,]  = 0,
LA = (a,-b,q,)   sl + (a,-b,q,)  q2-clql-c2q2-a=o.
From the first two equations we obtain  ql=q2[b2(al-c,) I/  [b,(a,-c,)   1;
replacing this equation into the third first-order condition, the
value of  q, that characterizes the solution is given by the
following expression:
(a2 -c2)
42' = b,+
-1/z .[ a,-c, 1 2 4b,cr (a2-c2)2
bz- b,  Lb, (al-c,)   2 +b, (a, -c2)  2l
2
.
Naturally, once  q; is computed from this equation for given values
of  CY,  ai,  bit and  Ci, for  i=1,2,   ql,  Pt and  Pi are immediately
<3>obtained, from which it can also be calculated the total cost  (Cl,
its composition between variable and fixed (VC/C) , and the
equilibrium price-elasticities of demand  (vl and  qZ). As it is well
known in the literature, this is just an exercise in Ramsey
pricing, where relative mark-ups are inversely related to the
price-elasticity of the demands in a way that minimizes the welfare
loss from the first best allocation (which we ruled out by imposing
the self-financing constraint, as such allocation would require
pricing at marginal cost and financing the fixed cost with a
transfer collected somewhere else).
The relevant question we are after here, though, is to see what is
the effect of a different belief held by the regulator about the
true composition of the total cost  C=a+c,qt+c,qi, when, furthermore,
the relation between the variable costs  (cl/c,) is common knowledge
(i.e., this ratio is known to be equal to  ,8). That is, we  ,want to
compare the price structure (P; and P;) when c, and c, change, and
the value of  (31 is adjusted in the amount of the estimated change in
the variable cost (i.e.,  cy'=cy-(c;-c,)   (@q;+qG)). In that sense, our
discussion applies very well to the context of tariff-rebalancing
in the face of technological (or judgement) change regarding the
composition of total costs.
3. Results.
We present the results of this exercise in table 1, where different
examples are constructed for different values of c,,  p, a,, a,,  b,and b,. The true situation is called "situation  O", whereas
situations 1 to 3 represent the solution to the problem when
alternative beliefs are held by the regulator about the composition
of total (observed) cost C,. IIj denotes the benefit obtained by the
firm in situation j, j=O,1,2,3, whereas  IIj,O is the level of profits
reached by the firm when the regulator believes the situation
prevailing is j when the true one is 0.
Note that the lltrue'V situation 0 is not necessarily the initial
one. Given the regulated prices prevailing in the status-quo
situation, quantities are given by demand functions, and different
cost structures are compatible with the observed total cost C,, so
that the initial situation (regarding technology) could correspond
to either one of them and therefore need not be optimal. It is an
important assumption, however, that the true and initial situations
be characterized by  C,,.4
4 If the description of the regulatory setting had an
initially unregulated monopolist choosing prices to maximize
profits, and only then a regulator came in and observed its cost,
he could also think of different technologies that were compatible
with it. However, in the  lltruell situation 0 to which the regulator
wants to go, the observed cost would be different (higher) than the
observed cost of the unregulated monopolist. It can be shown with
a simple example that beginning to regulate a monopolist with wrong
estimations of the cost structure would have an impact on the
quantities of both products and on profits that depends on the type
of mistake made. (See the following footnote.) The examples and
demonstrations below, though, refer to technologies that generate
the same cost as that of situation 0, but not necessarily that of
an initially unregulated monopolist.
<5>Table 1: Examples 1 to 5
Example 1: al=a2=20,  bl=l,  b,=2.
p = .5
Cl
c2
o!
91
cl2
Pl
p2
'j
'j
rll
Situation 3 Situation 0 Situation 1 Situation 2
2.2 2 1 0.5
4.4 4 2 1
3.354 10 43.23 59.846
17.66 17.59 17.27 17.13
7.74 7.82 8.18 8.35
2.34 2.41 2.73 2.87
4.52 4.36 3.64 3.31
76.27 76.46 76.87 76.76
0.00 0.00 0.00 0.00
0.13 0.14 0.16 0.17
0.29 0.28 0.22 0.20
0.96 0.87 0.44 0.22
-0.02 0.00 -0.41 -0.89
Example 2: a,=30,  a,=20,  bl=l,  b,=2.
p = .5
Cl 2.2 2 1
c2 4.4 4 2
01 1.298 10 53.512
91
q2
Pl
p2
cj
'Ij
rll
~j/Cj
II j/O
Situation 3
27.76 27.69 27.36 27.21
7.79 7.91 8.49 8.76
2.24 2.31 2.64 2.79
4.42 4.18 3.02 2.48
96.64 97.02 97.85 97.63
0.00 0.00 0.00 0.00
0.08 0.08 0.10 0.10
0.28 0.26 0.18 0.14
0.99 0.90 0.45 0.23
-0.04 0.00 -0.83 -1.83
Situation 0
<6>
Situation 1 Situation 2
751268Table 1 (continuation)
Example 3: a1=a2=20,  b,=l,  b,=2.
Ip=1
Cl 2.2 2 1 0.5
c2 2.2 2 1 0.5
01 4.713 10 36.433 49.649
cl1
q2
Pl
p2
cj
'Ij
rll
~'/Cj
nj,b
17.62 17.62 17.62 17.62
8.81 8.81 8.81 8.81
2.38 2.38 2.38 2.38
2.38 2.38 2.38 2.38
62.87 62.87 62.87 62.87
0.00 0.00 0.00 0.00
0.13 0.13 0.13 0.13
0.13 0.13 0.13 0.13
0.93 0.84 0.42 0.21
0.00 0.00 0.00 0.00
Situation 3 Situation 0
Example 4: a,=lO,  a,=15,  b,=l,  b,=2.
p=1
Cl
c2
a
q1
q2
Pl
p2
5
'Ij
rll
~j/Cj
l-I j/O
Situation 3
2.2
2.2
7.311
7.38 7.42 7.60 7.69
6.05 6.03 5.91 5.89
2.62 2.58 2.40 2.31
2.89 2.94 3.17 3.27
36.86 36.89 36.97 36.95
0.00 0.00 0.00 0.00
0.36 0.35 0.31 0.30
0.24 0.24 0.27 0.28
0.80 0.73 0.37 0. la
-0.003 0.00 -0.07 -0.16
Situation 0
2
2
10
Situation 1 Situation 2
Situation 1
1
1
23.447
Situation 2
0.5
0.5
30.171
c7>Table 1 (continuation)
Example 5: a,=15,  a,=lO,  b,=l,  b,=2.
p=1
Cl 2.2 2 1 0.5
cz 2.2 2 1 0.5
a 6.779 10 26.107 34.161
91
cl2
Pl
p2
'j
'j
rll
Situation 3 Situation 0 Situation 1 Situation 2
12.34 12.32 12.23 12.19
3.76 3.79 3.93 3.99
2.66 2.68 2.77 2.81
2.48 2.42 2.14 2.01
42.19 42.21 42.27 42.25
0.00 0.00 0.00 0.00
0.22 0.22 0.23 0.23
0.33 0.32 0.27 0.25
0.84 0.76 0.38 0.19
-0.002 0.00 -0.06 -0.12
The conclusions obtained upon observation of these examples are the
following ones:
1. Different beliefs held by the regulator about the composition of
the observed total cost between fixed and variable cost, being
correct about the relative marginal costs between different
products, generate different price structures with Ramsey pricing
whenever the equilibrium price-elasticity of demand differs among
goods.
2. When the believed fixed cost increases, the price of the good
whose demand is less elastic increases, and the price of the other
good decreases.
<8>3. Whenever the regulator is mistaken -i.e., either if he over or
under estimates fixed costs-, the profits of the regulated firm are
negative.5
4. Naturally, as a mistake is made, the sum of consumers' surplus
and the firm's profit is lower than the one under correct Ramsey
pricing. This is true even if there are distributive concerns that
indicate departures from pure Ramsey pricing, as those
considerations are properly accounted for by incorporation of the
distributive characteristic of the different  goods6  instead of a
miscalculation of the composition of total cost.
5. Changes in prices when estimated fixed costs go from 20% to 80%,
depending on the characteristics of the demands, may be significant
(up to  30%, comparing situations 0 and 2 in Example 1, for
instance), whereas induced losses could be higher than 1% of total
cost.
5 If a monopolist was initially unregulated, where the demand
functions are those corresponding to example 1, and the technology
is the one that corresponds to situation 0 in the same case, the
quantities that maximize profits are qI=9 and q;=4, resulting in
C*=44 and profits  (II) of 103. Observing  q;,  q; and  C', the regulator
sets new prices, with the following results: if he is right about
the technology (i.e., c1=2,  c,=4 and (w=lO),  profits are zero as
described in situation 0 (in particular C,=76,46);  if he
overestimates fixed costs compatible with q;, q; and C* (but not
with C,, i.e., cl=l,  c,=2 and  0!=27),  both prices are lower than
those of situation 0 and the regulated profits would be negative
(II=-17.98); finally, if he underestimates fixed costs  (c,=2.2,
c,=4.4 and  (r=6.6),  prices are higher and profits are positive
(II=3,18).
6 See Feldstein (1972).
<9>4. Discussion of Results 1 to 3.
Proof of Result 1. We can see from the first two first-order
conditions that  q,/q, varies with c,, when  c,=pc,,  with the sign of
a,-&,  t according to the following expression:
a+ = b, (al-Pa,)
a b, (aZ-c,)2  ’
Therefore, whenever a, is different than pa,, q,/q,  changes for
different values of c,, which means that PI/P, changes too. This
proves result 1.
Proof of Result 2. Accordingly, using those two first-order
conditions, it can be shown that a,>fla,  is equivalent (in this
linear setting) to r11~q2, indicating that q,/q,  increases with c,
whenever  r11~v2, and, equivalently, that  PI/P, increases when  c,
decreases under this same condition. Finally, if the two prices
changed in the same direction, the budget constraint would not be
respected, as total income and total cost would move in opposite
directions, whatever technology is in place (i.e., if prices
increase, total income also increases -with price-elasticities
lower than  l-, but since both quantities decrease, total cost
decreases).7 This proves result 2' above.
7 Even if the price-elasticities were higher than one,
provided that regulated prices are under the monopoly level,
marginal income is lower than marginal cost for both products,
meaning that an increase in both prices would generate a reduction
in production with a higher reduction in cost than in income.
clO>Proof of Result 3. Regarding result 3, note that total cost in
situation 0 is given by  C,=a,+c~q~+c~q~,  and by construction, if
technology is that corresponding to situation j, that same cost, of
producing the same output, is given by Co=aj+Clq~+C~q~, where by
construction  Uj-cr,=q~(c~-cl)+q,O(c,O-c~), as was previously pointed out
using different notation. Also, if prices are regulated in a Ramsey
manner for situation j, total cost in that situation is given by
Cj=~j+C~q~+C~qa, whereas if the true technology is that corresponding
to situation 0, total cost  Cj,O (i.e., the cost of producing Ramsey
output designed for situation j when the true technology is  0)  is
given by ~O+c~q~+coqj 2  2’ Thus, the expression for  Cj-Cj/o/ replacing  ~j-
a, above, and since  c,=pc,,  is given by
'jvcj/O   =  lc,j-C,")   lip   (CJ!-qF) + (&-&)I .
Note that, taking infinitesimal changes (denoting differentials
with  lldl') , the above expression indicates that  Cj-Cj,o<O  if and only
if P(dq,/dc,)  +dq,/dc,cO. From the previous result we know that
dq,/dc,>O  and dq,/dc,cO  when al>pa2 (case l), dq,/dc,cO  and dq,/dc,>O
when  a,c/3a,  (case  2), and dq,/dc2=dq2/dc2=0  when al=fia2  (case 3) .
Therefore, since values of  p lower than  al/a2 multiply the positive
term in case 1, and values of p higher than a,/a,  multiply the
negative term in case 2, a continuity argument, using case 3 where
P=a,/a, precisely balances the two terms of opposite sign, yields
Cj-Cj,,cO  for all  p different than  a,/a,.  Finally, since (regulated)
income is the same in both situations (as prices are regulated
assuming that situation j prevails), result 3  is obtained:
independently of the direction of the error in the estimation madeby the regulator, if such mistake is made, the level of profits of
the regulated firm (with respect to the one intended) is negative.
5. Concluding Remarks.
The results of this paper indicate that a sounded regulatory
practice facing a multiproduct firm could be to rely on it for the
estimation of fixed versus variable costs, although no implication
was derived regarding the relative variable costs themselves. This
is so because the firm has no incentive to misrepresent the true
figures, conducing then to the determination of prices that
maximize social welfare.
Nevertheless, that delegation to the firm is not free of problems.
First, as was mentioned in the introduction, there are dynamic
(strategic) considerations of the firm that might induce it to
report costs that generate a lower price for a product subject to
potential entry. Second, if the asymmetric information extends to
the demand curve, where the belief held by the regulator about its
position and shape is incorrect, and this is known by the firm,
there would be incentives to induce a price structure with a lower
(higher) price for the good with price-elasticity higher (lower)
than the one believed by the regulator, as the resulting income
would then be higher than expected by the regulator.'
a It is true that these features could be contemplated by the
regulator in order to  "correctI the choices made by the regulated
firm. The modelling of this interaction would require some sort of
signaling game in which the regulator extracts information from the
firm as an application of the Revelation Principle. Following this
<12>Acknowledgments
I would like to thank comments by Daniel Artana, Leonardo
Gasparini, Fernando Navajas, Albert0  Porto and Pablo Spiller.
Remaining errors are my own responsibility.
References.
Burns, Paul, 1994. "Discriminatory Pricing and Accounting Method in
the UK Regulated  Industries.t'  CRI. (As quoted by National Economic
Research Associates  (NERA), 1995, Final Report for the Ministry of
Economy, Republic of Argentina,  August, London.)
Feldstein, Martin, 1972. "Distributional Equity and the Optimal
Structure of Public Prices." American Economic Review  62(1):32-36.
Gabel, David, 1995. "Pricing Voice Telephony Services: Who is
Subsidizing  Whom?" Telecommunications Policy  19(6):453-464.
Oftel, 1993. Interconnection and Accounting Separation,  London.
Laffont, Jean-Jacques and Jean Tirole, 1993. The Economics of
Regulation,  Cambridge, MA: The MIT Press.
Kahn, Alfred E. and William B. Shew, 1987. "Current Issues in
Telecommunications Regulation: Pricing. I1  YaleJournal on Regulation
4:191-256.
Kaserman, David L. and John W. Mayo, 1994. "Cross-Subsidies in
Telecommunications: Roadblocks on the Road to More Intelligent
Telephone Pricing." Yale Journal on Regulation  11:119-147.
Parsons, Steve G., 1994. "Seven Years After Kahn and Shew:
Lingering Myths on Costs and Pricing Telephone Service." Yale
Journal on Regulation  11:149-170.
attempt, however, is left for future research.
<13>

Confusing Fixed and Variable Costs under Ramsey Regulation

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Confusing Fixed and Variable Costs under Ramsey Regulation

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