Optimal Pricing with Sunk Cost and Uncertainty

Abstract

When static models of the firm are considered regulators make serious errors in the determination of the proper wholesale price as the opportunity cost of the delay option is neglected. For an incumbent, the option is exercised and represents an opportunity cost. For a potential entrant the delay option need not be exercised should the regulator allow the purchase access at below economic cost, i.e., operating cost plus the delay options cost. Thus service-based entry is excessive and facilities-based entry remains suboptimal. To summarize, in a static-regulated paradigm: wholesale prices are below their economic cost; inefficient service entry occurs as prices are not set at the correct marginal cost while an entrant is not required to exercise a delay option; social welfare is suboptimal; incumbent firm’s valuation by the financial markets is less; and the cost of capital for incumbent firms is higher. When a regulated paradigm is dynamic the converse holds: optimal prices are higher than for static calculations; only efficient service entry occurs as prices are set at the correct economic marginal cost; facilities-based entrants receive correct price signals; social welfare is maximal; an incumbent’s valuation by financial markets is higher; and the cost of capital is lower than for a regulated paradigm. This chapter has demonstrated the profound implications for regulatory practices. In particular, dynamics and uncertainty matter for the realization of optimal regulatory pricing outcomes. However, much work remains to develop and quantify precise models to fit the telecommunications context.