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Fortnightly Magazine - September 1 1996

observe multipliers as low as 1.05 in the setting of "cost-based" rates. Unfortunately, this practice lacks all economic merit. Considering that the industry has largely broken itself of the habit of setting fully-distributed cost (FDC) prices for services, it is unsettling to confront the popularity of a pricing method that shares many of the economic infirmities of FDC pricing, and adds a few of its own.

The Telecommunications Act of 1996 will make the pricing of telecommunications services more critical, but formula pricing will not answer. The more competitive the market, the less valid a formulaic approach to pricing (em particularly where the formulas are based on specious assumptions to begin with. No formula can substitute for market-based pricing, especially in an industry poised to change dramatically (em as telecommunications will in the wake of the Act. t

Alexander Larson is senior economist in the regulatory and external affairs department at Southwestern Bell Telephone Co. in St. Louis, MO. Mr. Larson has an MS in economics from the University of Illinois, and is widely published in the area of telecommunications regulation. The author wishes to thank Curt Hopfinger, Dale Lundy, Tom Makarewicz, Doug Mudd, Steve Parsons, Terry Schroepfer, Margarete Starkey, and Jack Van Pelt for their valuable comments. Chris Graves assisted with research.

1. Telecommunications Act of 1996, Pub. L. No. 104-104, 110 Stat. 56, (sc 252(d)(1)(A)(i) (1996).

2. Telecommunications Act of 1996, Pub. L. No. 104-104, 110 Stat. 56, (sc 252(d)(1)(B) (1996).

3. For example, the Texas Public Utility Commission set the prices of integrated services digital network (ISDN) at a markup of 5 percent over incremental cost. TEX ADMIN. CODE tit. 16 (sc 23,69(f)(2)(D) ("To further the commission's policy that ISDN be made available at a reasonable price and that ISDN be as accessible as possible to those customers who want ISDN, [basic rate interface] should be priced ... at not less than 100% of [long run incremental cost] and at not more than 150% of [long run incremental cost].")

4. For example, in the paradigm of perfect competition, efficient cost-based prices are equal to marginal costs, and efficiency requires that prices not exceed marginal cost Ramsey pricing is a cost-based approach that uses demand elasticities to determine the most efficient ways for prices to exceed marginal cost.

5. This corresponds directly to the Act's concept of a "reasonable profit."

6. "Incremental cost" is the additional cost caused by engaging in a given economic action or decision, such as producing and marketing a service. For a service, incremental cost includes volume-sensitive costs and any service-specific volume-insensitive costs associated with the provision of that service, or change in the quantity supplied of that service. It excludes costs directly attributable to the production of other services, as well as unattributable costs that 1) are incurred in common for all the services supplied by the firm, and 2) do not vary with the level of output. The incremental costs of service are economic costs that represent the-forward-looking value of the resources caused to be used or expended by the provisions of that service.