proach and is the one which the EC proposes to be extended for mobile communication
markets in a recommendation of 07 May 2009.7 The alternative regulation scheme is
incentive regulation meaning either price- or revenue-cap regulation. Table 1 provides
an overview of the alternative regulation approaches which are in place in Europe.
Cost-based regulation forces termination rates to be chosen at cost-level or a constant
mark-up above costs. With cost-based termination rates investments in cost-reduction
are directly passed on to the investor’s termination rates. While the investment exter-
nalities on incoming calls are higher with cost-based regulation than without regulation
the wholesale price-cost margin remains constant. Concerning the effect on profits from
outgoing calls to the investor a stronger reduction in retail prices is observed since the
mitigating effect of cost-reduction on optimally chosen termination rates is abolished.
The price effect is overcompensated in the competitors’ profit functions by a higher
demand for outgoing calls. Note that LRIC regulation as it is usually defined in the
literature is a simplification of the more technical definition as it is given in Laffont and
Tirole (2001):
"LRIC=Marginal cost of date-t production of the most efficient technology × (Interest
rate + Rate of technological progress + Rate of physical depreciation of the equipment)"8
If LRIC regulation were introduced in the strict sense competitors were forced to reduce
their termination rates in line with an investment. In consequence, this would deter
the outcome twice: First, the investor’s retail price would decrease more than without
regulation and even more than with standard cost-based or incentive regulation as the
competitors’ termination rate reduction stronger affects the investor’s price-cost margin.
Second, the competitors’ wholesale price-cost margin would also be deterred increasing
the off-net traffic between competitors. Thus, under LRIC regulation the strategic-
instrument-character of investments is enhanced in the short-run (increasing incoming
traffic and reducing competitors’ profit margins). In contrast, with standard cost-based
regulation direct investment effects vanish as termination rates are unaffected by com-
petitors’ investments but are in place with the LRIC form.
With price-cap regulation an upper bound for termination rates is set by the regulator
based on a price basket of telecommunication services. Thus, by investing in cost-
reduction MNPs directly gain from a higher wholesale price-cost margin. Nevertheless,
7 http://europa.eu/rapid/pressReleasesAction.do?reference=IP/09/710&format=HTML&aged=
0&language=EN&guiLanguage=en
8see Laffont and Tirole (2001), p. 151
11
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