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Perspective

Fortnightly Magazine - September 1 1996

substantial gross margins.

Computers. In 1991, Compaq Computer offered personal computers (PCs) in the highly competitive computer market at prices that contained a 37-percent gross contribution margin.11 Even today, Compaq's gross margin target reaches 23 percent.12 IBM's numbers are similar: Gross margins run 48 percent on large servers; 40 percent on disk and tape drives; 33 percent on memory chips and PowerPC microprocessors; and 65 percent on software.13

Jeans. The contribution margin on a pair of jeans can be surprisingly large. Levi Strauss & Co. reports a 40-percent gross margin on sales in this industry, even though its market share is only 19 percent.14,15

Cereal, Cigarettes, and Razor Blades. Even after deducting the average value of coupons, cereal boasts a gross margin of about 20 percent.16 Philip Morris cigarettes run a margin of 32 percent, while Gillette blades and razors claim a whopping 36 percent.17

Souvenir Spoons. Even souvenir spoons, something nobody really needs, have a markup of over 400 percent!18

These randomly chosen examples of common household items demonstrate that regulatory markups of 5 or 10 percent over cost do not necessarily simulate the pricing behavior one would observe in a competitive market. The reason: Large markups are required to cover the joint and common costs and opportunity costs of competitive multiproduct firms. Looking at just the contribution margin for one product of a multiproduct firm does not tell the entire story. Similarly, applying competitively "small" contribution margins to regulated telecommunications services does not address the entire pricing problem.

Myth #2: Price Equals Long-run Marginal Cost

Basic economics tells us that, in the long run, a market reaches equilibrium when the market price equals both short- and long-run marginal cost as well as both short- and long-run average cost. At such an equilibrium, all costs are covered and profits are zero because prices equal average costs. This idea is fine as a theoretical maxim, but a literal and myopic reading can lead the policymaker astray.

The maxim applies most readily to a firm for which all costs may be directly attributed to a sole product. However, telecommunications companies are multiproduct firms that exhibit scale and scope economies as well as substantial joint and common costs.19 These costs are not included in any long-run incremental-cost calculation for any single product.

The maxim of P=MC implies that the sum of the separate long-run incremental costs for all of the products of a multiproduct firm add up to all of its costs, including the joint and common costs. This assumption simply isn't valid. Substantial joint and common costs are residual to the incremental-cost calculations, which is why we observe substantial margins in excess of long-run incremental-cost calculations for separate products in the real world.

Prices in competitive markets must cover not only incremental costs but also 1) the joint and common costs incremental to all services, and 2) the opportunity cost of capital. However, in applying "cost-based" pricing that is actually formula-based pricing, regulatory agencies may overlook these other costs (which can loom large for network-based industries such as telecommunications) and assume that markups