PUBLIC APPENDIX I TO ANNEXURE D OF
TELSTRA’S SUBMISSION IN SUPPORT OF THE
ULLS MONTHLY CHARGES UNDERTAKING
Efficiency of Delaying Recovery of Previously Incurred
ULLS-Specific Costs
PREPARED FOR
TELSTRA
NOVEMBER 2004
NETWORK ECONOMICS CONSULTING GROUP PTY LTD
ABN 72 006 819 969
NETWORK ECONOMICS CONSULTING GROUP
© Network Economics Consulting Group Pty Ltd 2005
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PUBLIC APPENDIX I TO ANNEXURE D OF
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Contents
1 Introduction
4
2 Demand Interrelationships
4
3 Elasticity of demand
5
4 Basic Marketing Principles
6
5 Conclusion
8
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1
Introduction
The Commission, in its Draft Decision, states that Telstra should recover previously
incurred ULLS-specific costs in future periods and that it is efficient to delay recovery of
these costs:
“Specifically, the approach allows more of the initial ULLS-specific costs to be
recovered by future demand. This is consistent with a [sic] Ramsey pricing which,
applied on an inter-temporal basis, indicates that more costs should be allocated to the
service at a time when it is better established and demand is more inelastic. Such an
approach accords with standard pricing of new products.”1
“This accords with basic marketing principles, it is pointless trying to recover all fixed
costs at the launch of a product, rather more fixed costs will be allocated when the
product is more well established and demand less elastic. That we do not see this price
rise in reality will usually be the result of increased efficiency in production.”2
“According to this approach, more of the costs should be allocated to future time
periods when the service is well developed. This view is consistent with an approach
which would nurture competition in its early stages.”3
Three points should be made in respect to the Commission’s views as set out above.
2
Demand Interrelationships
First, as the Commission itself has noted, inter-relationships in demands between periods
(or between products when determining relative markups between products) makes the
application of Ramsey-Boiteux pricing very difficult. Specifically, the Commission states:
“The Commission also notes that the Ramsey pricing approach may only apply in the
case where the demand for basic access and LSS services are not related, which may not
necessarily be the case. Any relation between the two services implies cross-elasticities
which could complicate the operation of the Ramsey pricing approach.”4
Clearly, there are substantial inter-relationships between demand for ULLS in different
periods. For example, it is almost certain that the pricing of ULLS today will impact
1
Australian Competition and Consumer Commission (2004), “Assessment of Telstra’s
undertakings for PSTN, ULLS and LCS: Draft Decision,” October 2004 (“Draft Decision”), at
page 41.
2
Draft Decision, footnote 116, page 63.
3
Draft Decision, page 63.
4
ACCC (2004), A final report on the assessment of Telstra’s undertaking for the Line Sharing
Service, August 2004, at page 32.
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demand for ULLS in the future, say by creating critical mass effects; equally, the future
price path for ULLS will affect current ULLS demand, especially if the decision to rely on
ULLS is difficult or costly to reverse. The Commission does not appear to have considered
these inter-dependencies of demands for ULLS between different periods when forming
its view on Ramsey-Boiteux pricing and specifically, on the issue of whether it is
appropriate to defer cost recovery. In effect, if the price path is known, then future higher
prices will be reflected in current demand, and assuming there are some costs involved in
reversing the decision to use ULLS, will tend to make demand more (rather than less)
price sensitive.
3
Elasticity of demand
Second, even putting those inter-dependencies aside, the Commission provides no
evidence that suggests demand in future periods will in fact be less elastic than demand
today. Indeed, the Commission provides no evidence in relation to an investigation of the
elasticity of demand for ULLS.
It is by no means certain that future ULLS demand will be less elastic. For example, it
may well be that ULLS is currently being used for applications for which there are few
alternatives to deployment by means of ULLS.
5
In future, technological alternatives to
ULLS, such as advanced wireless, may become far more readily available, eroding ULLS
demand. Moreover, even if the ULLS market grows, it may do so by extending to uses
where the individual willingness to pay is lower. As a result, even if the market expands, it
may not become any less elastic. Finally, as access seekers expand their own customer
bases, the option of directly rolling out fibre networks may become more attractive. As a
result, the Commission’s claim that ULLS will become less price elastic over time is
essentially speculative. It is difficult to see how the Commission could seek to apply
Ramsey pricing approaches on such an uncertain foundation.
This is all the more the case given that the Commission has clearly stated that it is
unwilling to apply Ramsey-Boiteux pricing principles in situations where demand
elasticities are not well known. For example, in its final decision on Telstra’s Line Sharing
Service Undertakings, the Commission stated:
“In terms of the Ramsey-Boiteux pricing approach advocated by AAPT, the
Commission notes that it is practically very difficult to implement given, amongst
5
For example, as at 31 October 2004 “c-i-c”% of ULLS services are used by access seekers to
supply SDSL, HDSL, or SHDSL. These services tend to be more sophisticated than cable and
wireless broadband and targeted toward business customers. Thus, it is likely that fewer
substitutes to ULLS exist for access seekers wishing to provide SDSL, HDSL and SHDSL and
demand is more inelastic than if there were many available substitutes.
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others, a lack of reliable information on price elasticity. Determining prices in this way
results in a higher than otherwise regulatory risk, particularly in comparison to a fully
distributed cost approach. For this reason, the Commission has not been supportive of it
in the past as a pricing mechanism and continues to hold this view.6
“The Commission notes that, in its submission to the Draft Report, AAPT provided
some indicative estimates of relative elasticities. However, the Commission maintains
its view that there are several obstacles in its implementation at the wholesale level,
including access to detailed knowledge of the demand conditions, and the requirement
for constant price changes as demand conditions vary overtime. Such informational
barriers are not insignificant, and could result in greater market distortions.”7
In its final decision on Telstra’s anticipatory exemption for Pay TV, the Commission
stated:
“In order to apply a Ramsey approach, robust estimates of demand elasticities are
required. The Commission’s research of the literature did not yield sufficiently robust
estimates of demand elasticities…In the absence of reliable demand elasticities, a proxy
is required.”8
4
Basic Marketing Principles
Third, the Commission claims that backloading recovery “accords with basic marketing
principles…more fixed costs will be allocated when the product is more well established.”9
However, a short review of basic marketing theory suggests that fixed costs are often
recovered to a disproportionate extent from early adopters, especially when it is difficult to
price discriminate as between high and low value users:
“Computers, computer programs, and first run movies are examples of this type of
product, and in general, we may expect durable goods, including information, to be
likely candidates. Products like these are often introduced on the market at a relatively
high price, at which time they are bought only by individuals who both value them very
6
ACCC (2004), A final report on the assessment of Telstra’s undertaking for the Line Sharing
Service, August 2004, at page 32.
7
ACCC (2004), A final report on the assessment of Telstra’s undertaking for the Line Sharing
Service, August 2004, at page 32.
8
ACCC (2003), Section 152ATA Digital Pay TV Anticipatory Individual Exemption Applications
lodged by Telstra Corporation and Telstra Multimedia: Final Decision, December 2003, at page
51.
9
Draft Decision, footnote 116, page 63.
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highly and are very impatient. Over time, as the price declines, consumers to whom the
product is less valuable or who are less impatient make their purchases.”10
“On the other hand, I think there is intertemporal price discrimination when the seller,
for example, plans for two periods and absorbs the demand from consumers who are
well-to-do and/or eager to buy during the first period by selling the book for 10
shillings. He can then absorb the demand from consumers with less purchasing power
and/or less eagerness to buy by selling the book for 6 shillings during the second
period.”11
And from a more theoretical perspective:
“In the fixed quality model, the pattern of intertemporal price discrimination is
apparent: the inframarginal consumers will purchase first and prices will decline over
time.”12
All of this accords with ordinary commercial practice, in which it is not unusual for a
greater share of fixed production costs to be recovered in earlier rather than later periods.
For example:
• book publishers price discriminate by charging inelastic customers higher prices for
hardcover books early in the product lifecycle and elastic customers lower prices for
paperbacks later in the product life cycle;
• distributors sell movies to inelastic customers in theatres for a relatively high price.
They then release the movie on video to more elastic customers for a lower average
price and subsequently sell to television stations to reach the most elastic customers for
an even lower average price.
• computer manufacturers charge higher prices to more inelastic early adopters and
reduce their prices later in the product lifecycle to reach more elastic customers; and
• clothing retailers often charge full price to inelastic customers for recently released
apparel. As time passes, retailers will discount the same apparel to reach more price
sensitive customers.
By way of further example, as illustrated in Chart 1, television prices in the US have
dropped significantly over time.
10
Stokey, N. L. (1979), “Intertemporal Price Discrimination,” Quarterly Journal of Economics,
Vol. 93(3), August 1979, at page 355.
11
Lofgren, K. G. (1971), “The Theory of Intertemporal Price Discrimination: An Outline,”
Swedish Journal of Economics, Vol. 73(3), September 1971, at page 334.
12
Kumar, K. (2002), “Intertemporal Price-Quality Discrimination and the Coase Conjecture,”
mimeo, University of Houston, April 2002, page 2.
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Chart 1
US City Average Television Price Index (1983=100)
180
160
140
Index
120
100
80
60
40
20
2003
1999
1995
1991
1987
1983
1979
1975
1971
1967
1963
1959
1955
1951
0
Data source: http://www.economagic.com/em-cgi/find.exe/form
This pattern will generally be efficient when early uses are typically higher valued relative
to later uses, and pricing is essentially uniform. This is likely to be the case with ULLS, as
the early uses are those for which there are relatively few alternatives. In contrast, later
uses are likely to face alternatives such as wholesale DSL services and access media (for
example, wireless and fibre optic) that compete with copper pairs.
5
Conclusion
In short, notwithstanding the fact that the Commission is hesitant to apply RamseyBoiteaux pricing without robust elasticity estimates, it has tried to do so in this instance
without any analytical estimate of the relevant elasticities.13 While the Commission asserts
that these elasticities will decline over time, it provides no evidence or argument as to why
this will be the case. Finally, the Commission is incorrect to assume that delaying the
recovery of ULLS-specific costs ‘accords with basic marketing principles.’ Indeed, much
marketing literature indicates that the opposite is true.
13
The Commission does provide the following text in footnote 132 of its draft report: “The
Commission estimates that the elasticity is around 2.” However, the Commission does not say
how this estimate was derived nor how robust it is.
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In these circumstances, to require Telstra to backload recovery of ULLS-specific costs is
merely a means of exposing Telstra to greater risk. However, the Commission has
provided no compensation for that increased risk, be it in the adjustment mechanism or in
the ULLS price itself. This is clearly inconsistent with the statutory criteria, and in
particular with Telstra’s legitimate interests in recovering costs that the Commission
forces it to incur.
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