Access price determination in a vertically integrated industry

We propose an access price determination approach, where the only regulatory instrument is the interconnection charge. Retail prices are set by unconstrained profit maximizing firms. We present a two stage model, solved backwards. In the second stage, the two firms compete freely, taking the access price as given. In the first stage, the regulator uses the information generated in the second stage to set the social welfare maximizing access price. We first assume a certainty model where firms have constant marginal costs. Firms may have different costs at the retail level and may choose either prices or quantities of the retail service. We find that the regulator generally provides the entrant with a subsidy (paid by the incumbent) in the form of an access price that does not cover marginal costs. A virtual (real) subsidy is provided when the incumbent has lower (higher) retail costs than the entrant. We then assume that the firms may not have constant marginal costs and that the regulated firm holds private information about its type. We determine an access pricing rule in which any excess of the incumbent's price over its marginal costs lowers the optimal access price. Finally, we use simulation models to compare our partially regulated model with a fully regulated model in which the regulator sets the interconnection and the retail prices. We find that when the integrated firm holds all the private information, the partially regulated model achieves a lower expected social welfare. Nevertheless, when the regulator and the regulated firm do not know the entrant's type, the partially regulated model can achieve a higher level of welfare. We also find that under uncertainty, the partially regulated model often results in the offering of one single contract regardless of the announced type of the incumbent.