1999 Productivity and Price Cap Regulation Articla

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Productivity and Price Cap Regulation:Theory and Practice

Presented to

Telecom 99

International Telecommunication Union

David N. TownsendPeter . !tern

October 1999


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Productivity and Price Cap RegulationITU Telecom 99

Table of Contents

I. INTR"DUCTI"N.......................................................................................................#

II. PR"DUCTI$IT% N&%!I! ND T'&'C"((UNICTI"N! R')U&TI"N.....*

2.1 The concept of productivity............................................................................................................................3

2.2 Productivity factors in Price Cap tariff regulation.......................................................................................3

III. PR"DUCTI$IT% C&CU&TI"N ('T+"D"&")I'!.........................................,

3.1. Options for productivity measures................................................................................................................5

3.2 Total Factor Productivity calculation method..............................................................................................6

Index Formula.....................................................................................................................................................7Alternative ratio formula.....................................................................................................................................8

I$. PP&ICTI"N "- ('T+"D"&")I'!................................................................9

.1 !efinitions" calculation of inputs and outputs...............................................................................................#

Definition of Inputs.............................................................................................................................................9

Definition of Outputs........................................................................................................................................10

.2 $easurement of input and output price changes %inflation&deflation'.....................................................11

$. DT R'UIR'('NT!.......................................................................................#*

5.1 Outputs............................................................................................................................................................13

5.2 (nputs..............................................................................................................................................................1

$I. ("D'& ND R'!U&T!......................................................................................#,

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I. Introduction

In the past decade or so as the telecommunications industr! in man! countries has

under"one a transformation from state#o$ned monopolies to a re"ulated and li%erali&in"private sector Price 'ap s!stems have emer"ed as the methodolo"! of choice for re"ulatin"

the prices of dominant operators. (his approach $hich $as first introduced %! Oftel in the)nited *in"dom in the mid#1980s upon the privati&ation of +ritish (elecom and has %ecome

the prevailin" re"ulator! mechanism in the )nited ,tates 'anada and other developed

countries has also %een $idel! adopted in the developin" $orld as a -e! component ofindustr! restructurin" and the esta%lishment of ne$ telecoms re"ulator! a"encies.

Althou"h specific Price 'ap formulas differ from countr! to countr! the! t!picall!are %ased upon a standard )P( * +formula under $hich chan"es to the prices that the

re"ulated firm can char"e for a defined %as-et of services depend upon %oth chan"es in

inflation /PI and chan"es in the productivit! of the firm.

2hile national measures of inflation are "enerall! availa%le in most countries

esta%lishin" the chan"e in productivit! of the re"ulated firm is far more challen"in". Indeed

in most countries $here price cap formulas are %ein" applied the productivit! factor hasso far %een set either ar%itraril! %! the re"ulator or throu"h ne"otiation %et$een the re"ulator

and the re"ulated firm. Other countries have simpl! ne"otiated price or revenue reduction

commitments $ith the re"ulated firm or have set an earnin"s tar"et and used the #factor toad3ust prices to$ard the tar"et in effect revivin" rate#of#return re"ulation. (his has %een

relativel! unavoida%le %ecause in most cases neither the data nor the processes necessar! to

esta%lish the productivit! factor have %een readil! availa%le.

4o$ever as ne$l! esta%lished re"ulator! %odies and privati&ed firms are

implementin" %etter cost accountin" procedures and as industr! li%erali&ation and expansion

is settin" in it is %ecomin" increasin"l! important to implement full! the principles of pricecap re"ulation includin" accuratel! accountin" for operator productivit! "ains. On the one

hand effective calculation of price caps should ensure fair and reasona%le tariffs for end

users of services that remain non#competitive. 5speciall! in developin" countriesunder"oin" restructurin" there should %e room for su%stantial "ains e.". a%ove 106 per

!ear as operators move a$a! from historical inefficiencies and the #factor in the price cap

formula is the most effective means for re"ulators to ensure that these "ains are passed on tothe pu%lic rather than $holl! retained as profits often %! forei"n euit! o$ners. At the

same time appl!in" appropriate price caps to dominant carrier services such asinterconnection char"es can also %e an important tool for supportin" fair competition.

(his paper presents a theoretical and practical %asis for esta%lishin" productivit!

factors for telecommunications companies re"ulated under price cap s!stems in developin"

countries. (he paper is %ased upon the authors experience $or-in" $ith the,uperintendencia de (elecomunicaciones in +olivia $hich re"ulates 1 local telephone

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cooperatives and a national lon" distance operator under a price cap re"ime and esta%lished

ne$ #factors for those companies in earl! 1999. 2e descri%e some of the practical

methodolo"ical challen"es faced in determinin" appropriate productivit! factors as $ell asthe %asic model applied.

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II. Productivity analysis and telecommunications regulation

/.# The concept o0 productivity

(he %asis for the concept of productivit! is the o%servation that the economicconditions of production of telecommunications services are not static %ut under normal

circumstances tend to improve over time reuirin" less input for the provision of the same

output or similarl! allo$in" the production of a lar"er uantit! of output for the same

amount of inputs.

'onceptuall! an! productivit! index is a measure of the chan"e in the de"ree of

efficienc! of an operator over time and focuses on the comparison of the consumption ofinputs reuired in relation to the level of output produced %! the operator.

'han"es in productivit! indexes t!picall! productivit! increases can %e caused %! avariet! of factors includin" the follo$in";

'han"es in the relative prices of inputs< e.". decreasin" trend in the cost of

telecommunications euipment and soft$ares a%ilit! to produce its arra! of services $ith

the resources that are availa%le to it.

/./ Productivity 0actors in Price Cap tari00 regulation

(he principles underl!in" most Price 'ap re"ulation re"imes are "enerall! fairl!simple. /ather than re"ulate individual telephone service prices directl! the re"ulator

esta%lishes a ceilin" or ?'ap@ on the $ei"hted avera"e prices of one or more ?%as-ets@ of

services. (his cap can chan"e over time accordin" to a formula that allo$s for increaseseual to the rate of inflation minus an ad3ustment to reflect expected productivit! "ains %!

the re"ulated operator.

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In this context productivit! improvements represent the de"ree of increased

efficienc! that the operator is expected to achieve or alread! has achieved in comparison$ith the national econom! as a $hole. In the case of telephone operators in developin"

countries B especiall! those that have %een recentl! privati&ed or $hose operatin" structure is

under"oin" si"nificant reforms B productivit! "ains should %e uite lar"e for several !ears.5ven in hi"hl! developed net$or-s such as the ).*. and ).,. productivit! factors have

often %een set in the ran"e of C6#6 or more in recent !ears.

(he Price 'ap re"ulation methods that have %een adopted in man! countries arelar"el! similar althou"h their treatment of productivit! differs considera%l!. ,ome examples

include;

Ar"entinas price cap s!stem doesnt include an explicit #factor provision

Australia uses a tradition 'PI# formula $ith different #factors for different %as-ets

initiall! set %et$een :6 and .6 risin" to 7.6 in 1997.

'anada has set the #factor at C.6 for the !ears 1998#:000 for re"ulated carriers.

'olom%ia utili&es a non#traditional re"ulatin" scheme $hich caps compan! costs rather

than prices %ut the formula does ta-e into account productivit! initiall! set at :6

throu"h :000.

=exico $as one of the first developin" countries to esta%lish a price cap s!stem. (heformula maintained a &ero #factor until 1999 $hen 'ofetel esta%lished a 6

productivit! offset for the next !ears.

Peru has a price cap s!stem $ith a ran"e for price chan"es allo$in" tariff fluctuation

$ithout an explicit productivit! factor.

In the )nited *in"dom $hich esta%lished the first price cap s!stem the current #factor

for +ritish (elecom is set at C.6 throu"h :001.

In the )nited ,tates at the national level the latest revision to the F''s price cap

formula incorporates a .6 #factor.

Eene&uelas price cap s!stem set a &ero #factor for the initial !ears throu"h 199

follo$ed %! a 1.6 #factor for lon" distance and international services &ero for other

services throu"h :000.

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III. Productivity calculation methodologies

*.#. "ptions 0or productivity measures

=an! successive means of measurin" productivit! have %een esta%lished historicall!in %oth academic literature and in re"ulator! practice. Althou"h the! "enerall! have in

common the reuirement to relate a value of input consumed to a value of output produced

the! can var! "reatl! in their level of sophistication and performance.

Ori"inall! most productivit! formulas $ere la%or#%ased productivit! measures such

as the often used measure of Output per Person Hour< the most sophisticated productivit!measures ho$ever such as the Total Factor Productivity(FP measure ta-e into

consideration all relevant inputs.

,ince most firms are multi#product firms the calculation of a productivit! measure

almost al$a!s reuires the a""re"ation of flo$s of inputs and outputs that are of differentph!sical natures. Different choices can %e made relative to the $ei"htin" factors to use

prices cost factors fixed or mo%ile $ei"hts etc. and to the definition of the price and

uantit! indices used in the a""re"ation formula.

Amon" earlier methodolo"ies the aspe!res and Paasche indices are closel! relatedand can %e derived from each other. aspe!res indices a""re"ate uantities and prices %ased

on fixed $ei"hts calculated in a $ei"ht %ase !ear allo$in" an eas! calculation of a""re"ate

uantities. Paasche indices on the contrar! recalculate the $ei"ht factors ever! !ear %ut also

tend to Ga"eG over time due to their reference to a fixed time %ase reuirin" periodicalad3ustments. +oth indices ho$ever tend to %ecome poor measures $hen the structure of the

industr! examined is under"oin" a rapid chan"e in particular $hen the chan"e is affectin"

the relative prices of inputs or outputs or the relative proportions of uantities of inputs oroutput.

Finall! the Divisia#(ornvist index of (otal Factor Productivit! is a more

complicated %ut more effective method of calculatin" price and uantities indices

particularl! in the context of a d!namic industr! $here production structures are chan"in"

rapidl!.

2henever data availa%ilit! permits its calculation (otal Factor Productivit! has %een

in recent !ears the preferred method for the calculation and monitorin" of

telecommunications companies productivit!. It is the method used %! the ).,. Federal'ommunications 'ommission amon" others. (he choice of (FP is prefera%le to a a%or#

%ased measure due to the importance of the capital factor durin" "ro$th periods.

Productivit! in telecommunications services provision is "enerall! sensitive to chan"es in the

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productivit! of capital. (his is due to the critical influence of net$or- euipment in the cost

characteristics of telecommunications carriers. Durin" "ro$th periods in $hich lar"e capital

investments are made into the net$or- in order to support fast expansion measurin" theproductivit! influence of capital is even more critical to the accurac! of the measure.

(he onl! do$nside of the (otal Factor Productivit! measure is that it reuires moredata than the traditional Output per Person 4our measure. In particular there is a need for

detailed accountin" data to determine the cost share of the various input factors considered in

the (FP formula. In man! developin" countries such data have not %een maintained or are

availa%le onl! in a""re"ate form. (he challen"e is to define data filin" reuirements earl!enou"h in the process to ensure that needed information $ill %e availa%le $hen the

productivit! anal!sis must %e performed.

*./ Total -actor Productivity calculation method

(otal Factor Productivit! =easures have in common a "eneral calculation formulathat relates the rate of chan"e of (FP to the rate of chan"e of the ratio of a""re"ate output to

a""re"ate input.1 A "eneral expression of this formula is the follo$in";

$here;Qis a $ei"hted a""re"ate index of all relevant compan! input varia%les from

iH1 to iHns total outputis "enerall! assumed to %e euivalent to its total revenuesfrom all services. In the case of

mixed re"ulated and unre"ulated activities the relevant measure of output is the revenues

from re"ulated services< ho$ever inputs must also %e distin"uished %et$een these t!pes ofservices as $ell. (here ma! %e cases $here chan"es in volumes of service provided are not

accuratel! reflected in chan"es in revenues; for example $here flat#rate usa"e tariffs appl!

or $here the structure of tariffs chan"es from one period to the next. (hese effects should

ideall! %e incorporated in the productivit! anal!sis e.". %! attri%utin" euivalent avera"e



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prices per unit of output from the different tariffs and measurin" the chan"e in per#unit

terms rather than actual revenues.

(he main cate"ories of telecommunications services for $hich chan"es in outputs are

t!picall! measured on a disa""re"ated %asis include the follo$in" $ith units of service;

+asic telephone service su%scription monthl! rents o$n

operatin" results and data rather than %road estimates of industr! capital costs chan"es.

One further ad3ustment that is sometimes applied to input costs in productivit! studies

is called an ?input price differential@. (his ad3ustment attempts to capture di++erences%et$een the input prices facin" the telecommunications industr! and price chan"es in the

econom! as a $hole. On the assumption that telecommunications euipment and related

prices have %een increasin" at a rate slo$er than "eneral inflation such an ad3ustment $ouldassure that the productivit! calculation reco"ni&es this %enefit to telephone operators e.". it

allo$s them to purchase more of the same euipment for a lo$er real price. If relevant data

are availa%le such a factor should also %e included in the anal!sis.

Finall! $ith re"ard to price chan"es affectin" the value of Outputs service

revenues it is most desira%le to rel! upon the actual tariff chan"es themselves as $ell as

avera"e measures of effective price chan"es. For services $ith simple tariff structures andavaila%le demand data direct chan"es in tariffs durin" the stud! period can %e used to

deflate revenues to %ase !ear price levels. For services $ith more complex tariff structures

e.". lon" distance services $e simplif! the anal!sis %! dividin" total revenues %! total

minutes of use in the %ase !ear. (his produces a $ei"hted avera"e tariff for that !ear $hichcan then %e applied to future !ear total demand levels to produce ad3usted future revenues.

2here revenues from several services are com%ined in the data it is necessar! to examinethe tariff chan"es for all services and estimate a $ei"hted avera"e price deflation index.

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$. Data re6uirements

(his section identifies the accountin" and other information that should %e provided

%! re"ulated telephone operators to allo$ for the calculation of productivit! trends accordin"to the methodolo"ies descri%ed. (he lists of data reuirements are not exhaustive and do not

necessaril! define in precise detail the exact format and scope of data that $ould %e mostuseful in conductin" the studies. or is it certain that the operators> accountin" s!stems and

data records $ill contain all of the desired information in the formats or de"ree of detail

identified here. Ideall! the information should %e provided as annual results for a period ofat least C !ears to the extent relevant and consistent data are availa%le.

,.# "utputs

+asic local services;

(otal num%er of %asic service su%scri%ers

(otal %asic su%scription revenues

(otal num%er of local exchan"e s$itches in the net$or-

(otal line capacit! of local s$itchin" net$or-

(otal minutes of local telephone usa"e if availa%le

(otal interconnection access minutes lon" distance international cellular

(otal interconnection access revenues lon" distance international cellular

on" distance services;

(otal minutes of national lon" distance usa"e %! tariff cate"or! if availa%le

(otal revenues from national lon" distance services

(otal out"oin" international minutes to each countr! or re"ion

(otal incomin" international minutes from each countr! or re"ion

(otal revenues from out"oin" international service

et settlement pa!ments from incomin" international services %! countr!

Other services;

(otal num%ers of leased circuits and data circuits %! t!pe of circuit

(otal revenues from leased and data circuits

(otal num%er of pu%lic telephones

(otal minutes of use from pu%lic telephones

(otal revenues from pu%lic telephones

(otal telex and tele"raph revenues

(otal revenues from other services

(ariffs for all services for each !ear identif!in" all chan"es in tariffs



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,./ Inputs

(otal compan! annual operatin" costs

(otal value of fixed assets in service as of %e"innin" of each !ear

(otal ne$ capital investments each !ear identif!in" nature of investment

(otal annual depreciation and amorti&ation expenses

(otal accumulated depreciation reserve if an! each !ear

(otal annual interest pa!ments on investment de%t

(otal annual real propert! taxes paid on fixed assets

(otal annual expenses for materials rents and services %! t!pe of cost

(otal annual la%orKpersonnel costs salaries $a"es %enefits %! t!pe of

emplo!ee

(otal num%er of emplo!ees %! t!pe of emplo!ee

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$I. (odel and Results



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(he follo$in" pa"es present the "eneral format and calculations alon" $ith sample

inputs and results from the productivit! model usin" data that is reasona%l! representative of

a local telephone operator>s performance durin" a period of "ro$th in a developin" countr!.(he example does not include lon" distance services $hich should t!picall! %e modeled

separatel! $hether or not the! are provided %! an inte"rated carrier.


Productivity -actor Calculations: !ample local telephone company

Input 0actor calculations

1995 199 199! 199" So#rces

$ABOR

1 Total salar%es an& benef%ts 'Bs( )9*99+*11, )5*,9"*!" ,5*""-*5 59*)9*15+ Data resonse f%l%n

- Deflat%on factor 1.+++ +."," 1.+99 1.,)! See %nflat%on calc#lat%ons

) d7usted la8or epense *92992##1 1#2;

9 A4erae re4en#e er s#bscr%ber ,1 ,-1 ,!! ,9) $!/$"

1+ 0ont?l2 tar%ff )! )! 5- 5- Data resonse f%l%n

11 d7usted total revenues 3?9, prices5 *,2;#,21/# 121,219; 1=2;;29* ,/2;=;2*/# $"$9'1995(

$ocal traff%c

1- Re4en#es )1*,-+*+"- )!*-1*5 1*111*1,, !1*19!*-"5 $1)$15

1) Total %n#tes -!!*-)*+1, )--*,!+*5 )!,*1,9*"- ,)5*9+1*!,- Data resonse f%l%n

1, A4erae re4en#e er %n#te +.11

15 Tar%ff er %n#te +.11 +.1- +.1 +.1 Data resonse f%l%n

1 d7usted total revenues 3?9, prices5 *#21/2;/ *=2,1=2==1 1/21*2=,# 1921/2#9< $1)$15'199,(

Interconnect%on Ser4%ces

Nat%onal $on D%stance

1! Re4en#es )"*1!9*+"- 5+*+!!*,15 59*5)5*559 "*,5*"9) Data resonse f%l%n

1" Total %n#tes 11*,9+*"1 1)*",9*5- 15*1)-*5,9 1*!+!*9)- >

19 A4erae re4en#e er %n#te ).)- ).- ).9) ,.1+ $1!/$1"

-+ A&7#ste& total re4en#es '@95 r%ces( )"*1!9*+"- ,*+1*1+ 5+*-!9*599 55*51)*9" $1"$19'1995(

Internat%onal $on D%stance

-1 Re4en#es 5!*!5,*),1 !5*+"-*)"1 ""*))1*,," 1+1*5"1*15 Data resonse f%l%n

-- Total %n#tes )*55)*+15 ,*)1)*-9 ,*)59*9!9 5*+1)*9! >

-) A4erae re4en#e er %n#te 1.- 1!.,1 -+.- -+.- $-1/$--

-, A&7#ste& total re4en#es '@95 r%ces( 5!*!5,*),1 !+*11"*1)9 !+*"!1*559 "1*5+-*-9) $--$-)'1995(

Cell#lar-5 Re4en#es -)*1+1*!) )+*+)-*95- )5*))-*5!9 ,+*)-*, Data resonse f%l%n

- Total %n#tes ,-*++)*15! 5,*+5*)" !"*51*",) 9+*-9,*)9 >

-! A4erae re4en#e er %n#te +.55 +.55 +.,5 +.,5 $-5/$-

-" A&7#ste& total re4en#es '@95 r%ces( -)*1+1*!) )+*+)-*95- ,)*1",*-) ,9*1*9+) $-$-!'1995(

-9 Total o0 ad7usted revenues ##92*,2#,9 #1=2#=


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Productivity -actor Calculations: !ample local telephone company

!ummary o0 Results

1995 199 199! 199" So#rces

RATIO CA$C

Documents

1999 Productivity and Price Cap Regulation Articla