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Cross-subsidization when Firms Are Allowed to make Non-zero Profits

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  • Jorg Borrmann
  • Klaus Zauner

Abstract

Faulhaber's (1975) concept of cross-subsidization is of crucial importance for regulatory activities. Its basic idea that customers demanding a good should not pay more than they would if they "stood alone" is a fundamental fairness rule which can be applied by independent regulators in infrastructure industries. In reality, however, regulators frequently do not restrict the pricing policy of a regulated firm to zero profits due to the influence of politicians and pressure groups or, in the case of state-owned firms, because of a mandate to generate profits to reduce the state's budget deficit. They approve of prices generating positive economic profits. In this case, Faulhaber's (1975) concept is not applicable. We develop a less restrictive concept of cross-subsidization which can be applied when regulators are not independent and allow firms to make non-zero profits. We generalize the usual stand-alone and incremental cost tests to the case when regulated firms make positive profits, and provide an equivalence result for the (generalized) stand-alone cost (GSAC) test and the (generalized) incremental cost (GIC) test.

Suggested Citation

  • Jorg Borrmann & Klaus Zauner, 2004. "Cross-subsidization when Firms Are Allowed to make Non-zero Profits," International Journal of the Economics of Business, Taylor & Francis Journals, vol. 11(2), pages 241-247.
    • Handle: RePEc:taf:ijecbs:v:11:y:2004:i:2:p:241-247
    DOI: 10.1080/1357151042000222546
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    References listed on IDEAS

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    1. Baumol, William J, 1982. "Contestable Markets: An Uprising in the Theory of Industry Structure," American Economic Review, American Economic Association, vol. 72(1), pages 1-15, March.
    2. Ronald R. Braeutigam, 1980. "An Analysis of Fully Distributed Cost Pricing in Regulated Industries," Bell Journal of Economics, The RAND Corporation, vol. 11(1), pages 182-196, Spring.
    3. D. A. Heald, 1997. "Public policy towards cross subsidy," Annals of Public and Cooperative Economics, Wiley Blackwell, vol. 68(4), pages 591-623, December.
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    1. Amundsen, Eirik S. & Andersen, Per & Jensen, Frank, 2011. "Testing for cross-subsidisation in the combined heat and power generation sector: A comparison of three tests," Energy Economics, Elsevier, vol. 33(5), pages 750-757, September.

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