Two views of applied welfare analysis: reply.

• Author: Wenders, John T.
• Position: Response to article by John W. Mayo, David L. Kaserman and David M. Mandy in this issue, p. 822 - Communications

1. Introduction

   My original article addressed the issue of an inconsistency between the popular Harberger welfare standard and an alternative standard that emphasizes the exhaustion of voluntary exchanges. I illustrated this inconsistency by showing that Harberger-optimal flat rate telephone prices may be unsustainable in a competitive environment.

   Without addressing the general point I raised, the preceeding comment by David L. Kaserman, David M. Mandy, and John W. Mayo (KMM) |1~ uses a simple example to show that unsubsidized flat-rate telephone prices may be sustainable against entrants offering measured service. They further assert that a Harberger optimal self-selecting tariff structure will be sustainable against competition, thus resulting in no discrepancy between the Harberger and voluntary exchange maximizing view of economic welfare.

   Their first assertion is dependent on the unique model used, and the second is incorrect once heterogeneity within the large customer group is recognized.

2. Firm-Fixed Costs: Plausible or Pathological?

   KMM's example illustrating the sustainability of flat-rate pricing depends on the presence of firm-level fixed costs. These are long run costs incurred by a firm even if it has no customers or product. Contrary to their implication that the presence of any "positive firm-level fixed cost" makes Harberger-optimal flat-rate pricing sustainable, their example depends critically on the size of these costs and other special assumptions. Consider the following.

   1. In the example used, firm-fixed costs make up 42.9% and 62.5% of total costs for the incumbent and entrant respectively. KMM offer no evidence on the realism of these assumptions. Intuitive empiricism and experience suggests that these percentages are high. In fact, since the presence of large firm-fixed costs imparts strong economies of scale, the co-existence of local telephone providers of widely different size argues against their importance.

   2. Instead of having market size and firm-fixed costs fixed at 100 customers and $1000 respectively, let us analyse their model generally for N customers and $Z of firm-fixed costs. Consider their equation (7), which depicts the profits of a maximizing entrant attempting to attract only the incumbent's small customers with a measured service offering. Setting this equation equal to zero, yields

      23N/9 - Z/3 = 0. (7|prime~)

      Following KMM, let N = 100 and solve for the level of firm-fixed costs that will allow...