On the identification of incremental and
common costs
An Analysys Consulting Working Paper for the PTS
1
Introduction
Without prejudice to any decision that the PTS might take regarding the appropriate basis
for the setting of regulated charges, this working paper discusses the problem of identifying
incremental and common costs in the context of setting ‘welfare maximising prices’.
2
The basics
Within a certain theoretical framework it can be shown that prices set equal to marginal
cost achieve the ‘first best welfare maximising outcome’1. However, in the presence of
common costs, and without any other source of revenue to offset such costs, suppliers
would be unable to achieve full cost recovery using marginal cost prices. If the additional
constraint of full cost recovery is imposed on the problem of identifying ‘welfare
maximising prices’ then a ‘second best’ outcome is achieved through the use of Ramsey
Pricing – prices set equal to marginal cost plus a mark-up sufficient to ensure full cost
recovery, where the mark-up applied to different products is inversely proportional to the
price elasticity of demand.2
We therefore see that, in order to implement ‘welfare maximising pricing’, it is necessary
to know the marginal cost of supply of each product, and also the common costs of supply
of each combination of products (including the common costs of supply of each individual
product, arising from any economies of scale in the supply of that individual product). In
this context it should also be clear that the common costs of supply can be identified as that
part of the total cost of supply that would not be recovered through marginal cost pricing.
1
It should be noted that this and other results are only strictly true within the constrained limitations of the relevant theoretical
framework. In practice there may be other factors at work which would invalidate these results.
2
This is not a paper about welfare maximising pricing, and we therefore do not concern ourselves with the full details of methods
such as Ramsey Pricing, we merely note the key features of the methods in order to be able to identify the characteristics of the
cost information required in order to implement them correctly.
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Analysys Consulting Working Paper for PTS
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Identifying marginal costs
Marginal costs are those that would arise as a result of a small increase in the volume of a
particular output. Unfortunately, in the context of mobile (and other telecoms) networks,
short-run marginal costs are highly variable as a result of the modularity of capacity: if the
small increase in demand can be accommodated within the existing capacity then the shortrun marginal cost will be zero; if not then a large cost will be incurred to increase the
capacity by more than enough to cope with the small increase in demand, and the
corresponding short-run marginal cost will be very high. It would not be appropriate (or
even practical) to set prices on the basis of such highly variable costs, and therefore it is
necessary to consider not short-run marginal costs but rather long-run marginal costs.
Long-run marginal costs are in effect a smoothed or averaged version of short-run marginal
costs. The challenge when calculating long-run marginal costs is simply to identify how, on
average, capacity and hence costs increase with demand at the margin – the total level of
cost is not relevant (although it will become of relevance again when the common costs
that remain to be recovered are to be calculated).
In the absence of significant economies of scale at the margin (by which we mean
curvature of the cost function rather than simply fixed costs3) long-run marginal costs can
be robustly estimated by reference to the incremental costs of larger increments, for
example entire services or groups of services.
As previously discussed, once the long-run marginal costs have been calculated, the
common costs are simply whatever of the total costs would not be recovered from marginal
cost prices.
3
Such economies of scale at the margin arise in fixed telecoms through factors such as increasing trunking efficiency, and the nonlinear increase in cost of transmission systems with bandwidth; in contrast mobile networks do not generally enjoy such
economies of scale at the margin.
On the identification of incremental and common costs
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Frequently asked questions
In the rest of this paper we address certain specific questions that are frequently asked in
the context of identifying the incremental (marginal) and common costs of mobile
networks.
4.1
Does a common cost arise as a result of the necessity to deploy a minimum number of
base stations in order to provide geographic coverage?
Not in those areas where the capacity of the minimum set of base stations is inadequate to
cope with current (or likely future) traffic levels. In this case these initial base stations are
no more than the first examples of the complete set of base stations that will be required in
order to cope with this traffic demand. Since a (long-run) marginal cost will clearly arise
from the need to install the additional base stations, and assuming that the unit cost of these
additional base stations is the same as that of the initial base stations4, then we can clearly
see that the costs of the initial base stations will equally well be recovered through
marginal cost pricing as are the costs of the additional base stations. Hence no common
cost arises as a result of the need to deploy a minimum number of base stations in such
areas.
However, if in certain geographic areas the base stations initially installed to provide
geographic coverage will have sufficient capacity to cope with all likely future demand,
then the marginal cost of additional traffic demand in such areas may indeed be less than
the average cost, and a part of the cost of such base stations may indeed be common cost5.
When considering this question in practice, it is necessary to differentiate between the
different components of base stations, in particular transceivers vs sector-specific
equipment vs site-specific equipment and infrastructure, since the modularity of such items
with respect to traffic demand differs significantly. It may well be that in some low-traffic
density areas site-specific equipment and infrastructure will give rise to common costs
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On a current cost basis.
We understand that Oftel does not entirely agree with this position.
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Analysys Consulting Working Paper for PTS
(since it is anticipated that there will never be a need to increase the number of sites) but
that transceivers and perhaps even sector-specific equipment give rise to incremental and
not common costs (since the current or forecast levels of demand will require an increase in
the number and hence cost of such items).
4.2
Are the costs of spare capacity arising from the modularity of equipment a common
cost?
Not if the (long-run) marginal cost of additional demand is calculated using a form of
economic depreciation that recognises the variations in utilisation of modular equipment
over time e.g. the Oftel model of economic depreciation, and if the (weighted) average
utilisation over time of the marginal unit is the same as that of the average over all units.
Using the Oftel model of economic depreciation, the level of unit output cost associated
with an item of equipment in any given year is determined by the (weighted) average
utilisation of that item of equipment over the lifetime of the network, and is entirely
independent of the utilisation of the item in the specific year of interest (other than to the
extent that the utilisation in that specific year is a component of the weighted average). It
therefore follows that, using this method of depreciation, the (long-run) marginal cost of
the marginal unit will be determined by its (weighted) average utilisation over time. If this
is the same as that of all other units on average, then the marginal cost so derived will be
equal to the average cost for all (other) units, and hence the common cost will be zero.
Whether or not the (weighted) average utilisation over time of the marginal unit will be the
same, higher or lower than the average is a priori not possible to say – it will all depend
upon the profile of future demand for the marginal unit as compared with that of the
historical (and future) demand for all other units.
If some other form of depreciation is used then it may indeed be the case that the
modularity of equipment will give rise to a common cost. In particular it is likely that a
cost equal to half of one unit of equipment will be identified as common cost, reflecting the
“average” unutilised capacity arising from the modularity.
On the identification of incremental and common costs
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