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In telecommunications, regulators turn increasingly to the nebulous term known as "cost-based" to set pricing policy. An example is the new Telecommunications Act of 1996 (Act), whose pricing standards for interconnection and network element charges stipulate that the just and reasonable rate for the interconnection of facilities and equipment should be "based on the cost ... of providing the interconnection or network element,"1 and "may include a reasonable profit."2 The notion of "cost-based rates" also surfaces in many state regulatory proceedings.3
To economists, however, cost bears no universal or formulaic relationship to price. Though it is not a term of art, "cost-based pricing" for the practicing economist usually denotes a price that relies on incremental cost as a price floor, and that exceeds this floor in efficient ways based on market information and other variables.4 But regulators often use the term "cost-based rates" to describe the setting of prices via some sort of formula, using cost data as the primary determinant. That notion bears scrutiny. While cost-based pricing itself is not objectionable, formula-based pricing should give cause for complaint when it is thinly disguised as "cost-based pricing."
In telecommunications, at least for local exchange carriers (LECs), regulatory agencies cannot reduce the rate-setting function to a concise formula (em such as by adding an appropriate ("just and reasonable") level of contribution to overhead to the "true" incremental cost to arrive at a price to charge the end user or intermediate supplier.5,6 Simplistic, formulaic methods will not likely arrive at prices that allow LECs to address the challenges posed by emerging competitors, changing consumer demand, or developments in technology. The post-Act world demands much more of pricing policy.
Though it sounds reasonable, formula-based pricing is the economic equivalent of one of Al Capp's shmoos, the affable, smiling, bewhiskered creatures that taste better than anything, and cheerfully cook themselves in a jiffy. It's too good to be true.
While it is certainly possible to use cost computations to arrive at prices that, at least "on paper," are subsidy-free and seem reasonable, such prices will quite likely prove absolutely meaningless in a competitive market.
Competition Means a Small Markup
The proponents of formula-based pricing would simulate a competitive price simply by appending a "competitive" markup to incremental cost. They presume that such markups are low. But in truth, neither the markup (a percentage of costs) nor the gross contribution margin (a percentage of price)7 follows any predictable pattern in competitive markets. Contribution margins for firms in fiercely competitive markets are surprisingly large, as illustrated by the following examples.
Compact Disks. If ever there was a competitive market, here it is. But record stores will purchase CDs for between $10.72 and $11.20, and sell them for $16.98, yielding markups over the wholesale price of between 52 and 58 percent.8 Such a markup equals
a gross contribution margin of between 34 and 37 percent.
Running Shoes. While Nike's midpriced running shoes cost only $15 to $20 to produce, they retail for four times the factory cost in the United States.9,10 This gap adds up to some