Two views of applied welfare analysis: comment.

• Author: Kaserman, David L.
• Position: Response to John T. Wenders, Southern Economic Journal, p. 340, October 1990 - Communications

1. Introduction

   In a recent article in this Journal, Professor John Wenders provides an exposition of applied welfare analysis, with an application to the pricing of local telephone service |4~. Such inquiries offer the dual hope of both improving our basic knowledge of the principles of applied welfare analysis and of bringing such principles directly to bear on practical economic matters. Accordingly, Professor Wenders is to be commended for undertaking this task. At the same time, however, fundamental aspects of his analysis are considerably less general than Professor Wenders's conclusions suggest. Accordingly, the purpose of this paper is two-fold. First, we point out the special assumptions upon which Professor Wenders's analysis is based and show how modest (and plausible) variations in the model yield substantially different conclusions. Second, we extend Professor Wenders's analysis to the case of self-selecting two-part tariffs. In this case, we argue that Wenders's alleged discrepancy between the Harbeger and voluntary exchange standards of welfare maximization disappears.

2. Background

   In his paper, Professor Wenders considers a firm providing local telephone service. The firm can offer either a flat-rate price, where consumers pay a fixed access charge and a zero marginal price per call, or local measured service (LMS), where the subscriber pays a reduced fixed access charge and a positive marginal price for usage.

   The firm's costs are incurred according to

   C(q) = {N|C.sub.A~ + cq if the tariff is flat rate, or {N|C.sub.A~ + (c + m)q if the tariff is LMS,

   where q is firm output, N is the number of customers served (assumed constant for all prices considered), |C.sub.A~ is the customer-specific fixed cost incurred by the company, c is constant marginal cost, and m is the constant marginal cost associated with measuring usage.

   Prices in Wenders's model may be regarded as two-part tariffs (p, E), where p is the marginal price and E is the access charge. The incumbent firm is assumed to break even, so tariffs under the two alternative pricing regimes are

   |Mathematical Expression Omitted~

   where |q.sub.i~ is the consumption of individual i.

   Professor Wenders analyzes the sustainability of these prices under the alternative assumptions of homogeneous versus heterogeneous consumers, and welfare dominant LMS versus welfare dominant flat-rate pricing, where "welfare dominant" means that the surplus of an average consumer is larger under the dominant tariff structure. Either tariff can dominate in this sense because aggregate measurement costs may either be larger or smaller than the deadweight loss associated with the (non-marginal cost price) flat-rate tariff. When consumers are homogeneous, Wenders shows that if LMS welfare dominates flat-rate pricing then the viability of equally efficient competitors will force the incumbent firm to adopt LMS. Similarly, with homogeneous consumers, if flat-rate pricing welfare dominates LMS, competition will force the implementation of flat-rate pricing.

   In the more provocative (and realistic) case, however, consumers are allowed to be heterogeneous in their usage characteristics. In this case, Wenders argues that even if flat-rate pricing welfare dominates LMS, it will nonetheless prove unsustainable from competition. The basic reason for this unsustainability is that flat-rate prices must be set to recover the costs of the "average" consumer. But when some customers are smaller than average, the "prices" these customers face exceed their stand-alone costs and, therefore, the small customers will prove susceptible to competitive attacks from entrants who offer LMS. Thus, Professor Wenders draws "the immediate practical conclusion . . . that flat-rate telephone service is not sustainable, even if it is optimal in a Harberger benefit/cost sense"(1) |4, 347~. In the following section, however, we show from a theoretical perspective that this principal...