Interconnection—firm-to-firm service that is necessary to serve final users—has become one of the most important issues of the evolution of network markets and that of industry regulation. Incumbent network operators can exercise monopoly power over other companies and against ultimate users.
The dominant market power of the owners and operators of a network calls for price regulation in these industries. Price regulation, including the regulation of interconnection charges, is based on the principle of “cost-based pricing.” That is, regulators demand that network operators provide access to their network for other service companies for a charge that is based on “long run incremental costs,” which is basically the long run marginal cost of interconnection services. Applying cost-based pricing by a regulator implicitly assumes that the regulator has perfect information about the operators’ costs of interconnection.
The principle of cost-based pricing dominates the regulatory approaches to network industries all over the world. We shall show in this paper that—under fairly general conditions—cost-based pricing may give “perverse” incentives to firms not to improve their efficiency in interconnection. In addition, basing prices on costs would require much more relevant information than the regulators can ever have. Cost-based pricing can be extremely costly also in terms of lost social welfare, as we shall show.
Several studies discussed the issues of optimal interconnection pricing and an equal number of analytic papers addressed the problem of asymmetric information, but we are not aware of any that would have combined these two issues. We extended the analysis by addressing the issues of asymmetric information between service providers and regulators, using the example of the telecommunications industry, but our findings hold for any network industry where networks interconnect.
The regulatory model of access and interconnection with imperfect information conveys important policy implications beside the theoretical niceties of the modeling exercise. We show that incentive regulation gives the proper incentives to firms to improve efficiency, and it works with smaller social welfare loss than cost-based pricing or bottom-up cost accounting.
The structure of the paper is as follows: we outline the modeling assumptions; we present the benchmark case of regulation with perfect information and cost-based pricing; we describe a model of incentive regulation with two different effort levels and with two efficiency types of the firms; and solving the model we discuss the results and compare with other pricing policies.