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Review of Law & Economics

Editor-in-Chief: Parisi, Francesco / Engel, Christoph

Ed. by Cooter, Robert D. / Gómez Pomar, Fernando / Kornhauser, Lewis A. / Parchomovsky, Gideon / Franzoni, Luigi

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Volume 9, Issue 1


Price Regulation and the Financing of Universal Services in Network Industries

Christian Jaag
Published Online: 2013-09-26 | DOI: https://doi.org/10.1515/rle-2012-0007


This article explores the complementary roles of price regulation and universal service regulation in network industries. It analyzes compensation for the universal service provider (USP) by public finances and a fund to which operators contribute. As long as the USP enjoys market power, price regulation may serve as a means to finance universal services. This implies allowing for price increases to compensate for the net cost of the universal service obligation. It releases competing operators or the general government budget from contributing to its financing but results in distorted pricing and reduced overall welfare due to inefficient entry. The analysis shows that current practices of costing and financing universal services may result in unintended market distortions. The article quantifies these effects and demonstrates how such distortions can be avoided.

Keywords: universal service obligation; price regulation; postal sector; telecommunications; network industries; net cost of the USO


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About the article

Published Online: 2013-09-26

See, for example, Billette de Villemeur et al. (2003) for the postal sector and Tardiff and Taylor (2003) for telecommunications. For example, Laffont and Tirole (1990a, 1990b) discuss price regulation in multiproduct firms in general. CERP (2009) finds that there is no universal solution for postal price regulation. Postal regulators have to determine which price regulation mechanism (or combination of mechanisms) best suits their circumstances and objectives for their postal market.

The article does not weigh in on the current debate about the appropriate scope of the USO. See Jaag and Dietl (2011) for a discussion of how the USO might be adapted in the future.

See, for example, the recent report by Frontier Economics (2013) for the European Commission.

See Panzar (2000) and Cremer et al. (2000). Annex I of the Third Postal Directive defines the net cost calculation as follows: “The net cost of universal service obligations is any cost related to and necessary for the operation of the universal service provision. The net cost of universal service obligations is to be calculated, as the difference between the net cost for a designated universal service provider of operating with the universal service obligations and the same postal service provider operating without the universal service obligations.”

See Copenhagen Economics (2008), Bergum (2009), Frontier Economics (2008) and Cohen et al. (2010) for recent applications of the profitability cost approach in the postal sector. Jaag et al. (2011) discuss these approaches. The European Committee for Postal Regulation (CERP) has published guidelines for calculating the net cost of the USO in the EU, see CERP (2008). The European Regulators Group for Postal Services (ERGP) has issued a draft Report on net cost calculation and evaluation of a reference scenario, see ERGP (2011).

See BEREC (2011) for a discussion of current policy issues in telecommunications in the EU.

See Armstrong (2008) for an analysis of access pricing in the context of a USO.

See Jaag (2011b) for a discussion of various notions of an unfair burden.

The same rules for compensating the net cost also apply in the telecommunications sector; see Directive 97/33/EC on interconnection in telecommunications with regard to ensuring universal service and interoperability through application of the principles of Open Network Provision (ONP) and Directive 2002/22/EC (Universal Service Directive).

Article 1 of Directive 2002/39/EC, amending article 12 of the 97/67/EC Directive.

We refer to the incremental cost associated with serving a market as “incremental coverage cost” in the sense that it is the cost incurred when an operator extends its regional presence incrementally.

There is no general uniform pricing and affordability constraint in the model. In many countries, there are USO products which have to be delivered nationwide but are not subject to a uniformity or affordability constraint (e.g. bulk mail). We discuss scenarios with and without uniform pricing constraints to compare the respective competitive effects.

There is no reason for price differentiation within markets if the number of operators is same, because marginal costs do not vary across regions.

Transactional mail is often originated by recipients who choose to have a mail item delivered by the post instead of electronic alternatives. The importance of doorstep delivery for these customers is empirically demonstrated, for example, by Friedli et al. (2006). Due to the recipients’ preferences, also senders of direct mail highly value doorstep delivery compared with P.O. box delivery.

In the past, the postal USO generally called for uniform prices. With increased liberalization, this obligation has been relaxed in many countries. The Third Postal Directive even requires that any uniform tariff obligation be limited to single-piece items (mainly stamps and franked mail). Hence, the assumption of differentiated prices is plausible in the postal sector. Many postal operators effectively differentiate prices across geographical areas in their rebate system for large mailers.

In our model, it is the sequence of decisions that results in the incumbent always serving at equilibrium a larger proportion of the market. This sequence reflects that the incumbent operator has traditionally been serving all markets due to the USO.

Since the model is deterministic and there are no information asymmetries, the contributions to the fund just match the predetermined compensation.

For simplicity, it is assumed that there is no shadow cost of public funds.

See Copenhagen Economics (2010) for an overview.

These license requirements are inconsistent with the Third Postal Directive as competing postal companies other than the universal service provider cannot be required to deliver mail 5 days per week.

The Third Postal Directive does not impose a specific tax base for the compensation fund. The tax could also be based on profit, turnover or other variables (see, e.g. Gautier and Paolini, 2011, or Jaag and Trinkner, 2011).

In practice, the difficulty with a “pay-or-play” system is to define the balance between the provision of universal services and the reduction of the contribution to the fund. Here, we simplify by not differentiating between various degrees of universal service provision. Given the choice between providing full USO (together with the incumbent) and none, it is optimal for the entrant to “pay” and not to “play” in all scenarios discussed below.

Hence, it is assumed that demand supports prices such that USP is able to break even.

Recall that the specification exhibits no cross-side effects between regions on the demand or cost side.

See Jaag and Trinkner (2011).

This setting is typical for the postal sector in many countries where prices are subject to direct approval (e.g. in Switzerland) or price cap regulation.

We assume that only the USP’s prices are regulated, not the entrant’s.

The model calibration allows the market that actually supports such an equilibrium.

Citation Information: Review of Law & Economics, Volume 9, Issue 1, Pages 125–150, ISSN (Online) 1555-5879, ISSN (Print) 2194-6000, DOI: https://doi.org/10.1515/rle-2012-0007.

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