Elasticity Based Pricing Rules in Telecommunications - a Cautionary Note

To recover large common (sunk) costs, telecommunications operators are often recommended to follow an inverse elasticity based pricing; setting the highest markups for the services with the least elastic demand. This is based on the seemingly simple rule for profit maximization proposed in many microeconomics textbooks for marking up marginal cost. This inverse elasticity rule also appears in the well-known Ramsey rule, which has been frequently debated as a regulators tool for curbing monopoly pricing in telecommunications while minimizing deadweight losses. The inverse elasticity rule is all too often described in a way that implies a myopic application, usually with a numerical example with input values for price elasticity of demand and marginal cost thus determining profit maximizing price (e.g. Dobson, Maddala, and Miller, 1995, or Mansfield and Yohe, 2000). This is unfortunate, as management in telecommunications and other industries may adopt the rule at face value. However, if marginal cost and price elasticity depend on price, as is usually the case, a straightforward application of the rule will, in most cases, lead to an overshooting of optimal price; if the initial price were too low, then the prescribed price would be too high, and vice versa. Continued myopic use may even lead to divergence from the profit maximizing price. Only if both price elasticity of demand and marginal cost are constant, which is rarely the case, will the rule return the optimal price.