Contrasting approaches to the ‘problem’ of cross subsidy

Abstract

The definition and measurement of cross subsidy, which has emerged as an issue in utility regulation, is one of management accounting's most pronounced interfaces with public policy. Analytical clarity is essential, particularly because this is a context in which language is used both imprecisely and persuasively. Benchmarks from which cross subsidies are to be measured must be defined. Two contrasting approaches are identified: the first starts from cost allocation and the second from optimal pricing. Whereas cost-based theoretical tests for cross subsidy are typically defined in terms of Stand Alone Cost and Incremental Cost, most regulatory discussion and empirical work resorts to various forms of Fully Distributed Cost. However, the economic literature on public and regulated industry pricing insists upon the primacy of pricing, denying that cross subsidy can sensibly be measured exclusively in terms of cost. Whilst market liberalization and denationalization will lead to the elimination of socially motivated cross subsidy, other than that imposed by regulation, more aggressively profit-seeking enterprises will view the predatory use of cross subsidy as a tool of commercial policy. The discussion of cross subsidy in a regulatory context constitutes a highly convenient vehicle for raising issues of much broader relevance to management accounting research and practice.