When the operator has market power,² its profit-maximizing prices will exceed their marginal costs in most situations.³ This causes a loss in welfare relative to the perfectly competitive situation, so the government has an interest in lowering prices to their respective marginal costs. However, as noted in Chapter II on Market Structure and Competition, marginal-cost pricing may not be financially feasible for the operator because of scale economies, fixed costs, or joint and common costs.⁴ When this is the case, the profit maximizing price structure for the monopoly operator is one that causes the quantities that customers want to purchase to deviate as little as possible from what customers would purchase with marginal-cost pricing. This system of pricing, called Ramsey Pricing or the inverse elasticity rule, raises individual prices above marginal cost in according to each service’s price elasticity of demand.⁵ Mark-ups above marginal cost are lower for services with more elastic demand, and conversely mark-ups are greater for services with more inelastic demand.⁶

Ramsey pricing is sometimes consistent with the government’s objectives because Ramsey pricing is economically efficient in the sense that can maximize welfare under certain circumstances. There are, however, problems with Ramsey pricing. A profit-maximizing operator will choose Ramsey prices only if all markets are equally monopolistic or equally competitive. If markets are not equally monopolistic or competitive, then the regulator has an interest in taking steps to ensure that the extent to which the operator can use Ramsey pricing is limited to groups of services that are subject to similar degrees of competition. Regulators typically do this by forming baskets of services that are subject to similar degrees of competition and allowing the operator price flexibility within each service basket. Chapter IV on Regulating the Overall Price Level describes how service baskets are used in incentive regulation.

Even though Ramsey pricing can be economically efficient, it may not be consistent with the government’s goal of providing affordable service to the poor and the rate by which prices change to achieve Ramsey-efficient prices may not be consistent with political sustainability. As a result of these two concerns, the regulator sometimes limits the operator’s ability to pursue Ramsey pricing within a service basket. In the case of services to the poor, the regulator may place upper limits on the prices. In the case of services where traditional prices were different from Ramsey prices, there are equity issues in changing from the traditional pricing structure to a new structure, even if the new structure would be more efficient in an aggregate sense. In such situations, the regulator may impose pricing restrictions that prevent Ramsey pricing or that impose a slower transition to Ramsey pricing than the operator would choose left to its own devices.⁷

Lastly, regulators often note that Ramsey pricing is a form of price discrimination -- although not necessarily a bad form of price discrimination – and customers sometimes object to it on that basis. The public sometimes believes that it is unfair to cause one type of customer to pay a higher mark-up above marginal cost than another type of customer. In such situations regulators may further limit an operator’s ability to adopt Ramsey prices.

FOOTNOTES

1. See Sections A and B. Back to Content
2. Chapter II Section A provides information on market power. Back to Content
3. Exceptions might include situations where the sales of one product stimulate the sales of another product. For example, shortly after the development of telephone service in the U.S., AT&T chose to price residential service below marginal cost in order to stimulate sales of business service, which could be priced above marginal cost. Back to Content
4. Joint costs are costs that, once incurred, produce two or more services in fixed proportions. Joint costs are efficiently recovered by using Ramsey pricing. Common costs are costs that are incurred to produce one service and that do not have to be incurred again to produce one or more additional services. Most regulators use some form of cost distribution to deal with common costs. Ramsey prices are also efficient for recovering common costs. Section D provides further information on this topic. Back to Content
5. See Sections A and B. Back to Content
6. The greater the elasticity of demand, expressed as a positive number, the more customers change the quantities they purchase in response to a change in price. If customers change the quantities they purchase by more than 1 percent in response to a 1 percent change in price, then demand is elastic and the elasticity of demand is greater than 1 when expressed as a positive number. Demand is inelastic if customers change their purchases by less than 1 percent in response to a 1 percent change in price and the elasticity of demand is less than 1 when expressed as a positive number. An elasticity of demand equal to 1 is called unitary elasticity of demand. Back to Content
7. Chapter IV Section B provides further information on price constraints within service baskets. Back to Content