DYNAMIC PRICING WITH UNCERTAINTY

The efficiency results of marginal-cost pricing have been used to justify the imposition of regulatory policy tools to determine optimal pricing. In the more sophisticated form, Ramsey-Boiteux pricing methodology is recommended as a pricing-policy tool. These methods are static. Nevertheless, they are applied to major infrastructure industries such as telecommunications. At best, these methods assume prospective events with certainty; they do not account for stochastic changes in cash flows. However, uncertainty can make a substantial difference in the determination of optimal prices. Moreover, significant sunk (irreversible) costs are incurred by the incumbent firm in these industries. Once the sunk costs are incurred, the firm no longer has the delay option available, that is the firm cannot wait-and-watch how the market develops, but must invest immediately. This opportunity cost has not been acknowledged by the regulatory community in its pricing decisions. In addition to the neglect of opportunity costs, regulators have additional impacts on the incumbent firm’s cost of capital. We first develop a model with sunk costs which determines the optimal price in the spirit of