The law and economics of price floors in regulated industries.

I. Introduction

A price floor, as its name implies, is the absolute minimum price that a firm is permitted to charge for the product or service that it sells. In general, an efficient price floor should be set at a level that reflects all of the incremental resource costs borne by the firm in producing the retail service in question. The primary economic rationale for a price floor is to prevent predatory pricing or an anticompetitive price squeeze.

An anticompetitive price squeeze occurs when the vertically-integrated provider (VIP) engages in some combination of raising the price of the upstream input to production and simultaneously lowering the price of the downstream retail service. (1) These actions serve to "squeeze" the price-cost margins of rivals and may force relatively efficient rivals to exit the market. In theory, once the rivals exit the market, the VIP raises the price of the downstream product--recovering its earlier losses and harvesting additional gain. (2) Hence, an anticompetitive price squeeze is a particular form of predatory pricing.

Price floors or imputation constraints are common in regulated industries. (3) In the telecommunications industry, incumbent local exchange carriers are generally subject to price floors for both their long-distance and local telephone service offerings. (4) Similar rules apply to incumbent electric power companies that are vertically integrated into the generation, transmission and distribution of electricity. These constraints are designed to ensure that the regulated VIP does not leverage its bottleneck control of an essential input to production in the upstream market to realize an artificial competitive advantage in the downstream retail market.

This analysis is motivated by two questions. The first question concerns whether price floors are serving their intended purpose--that of protecting the competitive process. (5) The second question concerns the computation of efficient price floors in the presence of emerging competition in upstream markets and increased product differentiation in downstream markets. The answers to these questions naturally harbor important implications for public policies in regulated industries undergoing a transition to competition. (6)

The format for the remainder of this article is as follows. Section II provides an overview of the key elements necessary for a price squeeze. Section III discusses how price floors can be used strategically by rivals to peg downstream prices at artificially high levels and thereby realize a competitive advantage. Section IV derives a general rule for computing efficient price floors based on the intensity of competition in upstream markets and the degree of product differentiation in downstream markets. Averaging of downstream prices under the price floor constraint is discussed in section V. Section VI examines the rationale for relaxing the price floor constraint on the basis of asymmetric risk-bearing. Section VII summarizes the policy implications of this analysis and concludes. The appendix contains formal proofs for selected results in the main body of the article.

II. Elements of a price squeeze