Access pricing and investment: a real options approach

Abstract: This paper examines a three-period model of an investment decision in a network industry characterized by demand uncertainty, economies of scale and sunk costs. In the absence of regulation we identify the market conditions under which a monopolist decides to invest early as well as the underlying overall welfare output. In a regulated environment, we consider a vertically integrated network provider that is required to provide access to downstream competitors and compare two distinct access pricing methodologies: the ECPR and the ODPR, an option to delay pricing rule. We identify the welfare-maximising access prices using the unregulated market output as a benchmark and show that optimal access regulation depends on market conditions (that is, the nature of demand) and there are two possible outcomes: (i) access prices that provide a positive payoff to the incumbent, that is, provide a positive compensation to account for the option to delay; and (ii) access prices that yield a zero payoff to the incumbent. Moreover, unlike the earlier literature that argues in favour of an ECPR-type methodology to account for the interaction between irreversibility and demand uncertainty, we find that, except under very specific conditions, an access price that accounts for the option to delay value is welfare-superior to the ECPR