Ramsey problem

The Ramsey problem, or Ramsey–Boiteux pricing, is a policy rule concerning what price a monopolist should set, in order to maximize social welfare, subject to a constraint on profit. A closely related problem arises in relation to optimal taxation of commodities.

It is applicable to public utilities or regulation of natural monopolies, such as telecommunications firms.

For any monopoly, the price markup should be inverse to the price elasticity of demand: the more elastic demand for the product, the smaller the price markup. It was recognized that Frank P. Ramsey found such a result in 1927 in the context of taxation. The rule was later applied by Marcel Boiteux^[] (1956) to natural monopolies (decreasing mean cost): a natural monopoly experiences profit losses if it is forced to fix its output price at the marginal cost, subject to Economies of Scale being exhausted. Hence the Ramsey–Boiteux pricing consists into maximizing the total welfare under the condition of non-negative profit, that is, zero profit. In the Ramsey–Boiteux pricing, the markup of each commodity is also inversely proportional to the elasticities of demand but it is smaller as the inverse elasticity of demand is multiplied by a constant lower than 1.

Ramsey pricing is sometimes consistent with a government’s objectives because Ramsey pricing is economically efficient in the sense that it can maximize welfare under certain circumstances. There are, however, problems with Ramsey pricing. A profit-maximizing operator will choose Ramsey prices only if all markets are equally monopolistic or equally competitive. If markets are not equally monopolistic or competitive, then the regulator has an interest in ensuring that the extent to which the operator can use Ramsey pricing is limited to groups of services that are subject to similar degrees of competition. Regulators typically do this by forming groups of services that are subject to similar degrees of competition and allowing the operator price flexibility within each service group.

Even though Ramsey pricing can be economically efficient, it may not be consistent with the government’s goal of providing affordable service to the poor and the rate by which prices change to achieve Ramsey-efficient prices may not be consistent with political sustainability. As a result of these two concerns, the regulator sometimes limits the operator’s ability to pursue Ramsey pricing within a service group. In the case of services to the poor, the regulator may place upper limits on the prices. In the case of services where traditional prices were different from Ramsey prices, there are equity issues in changing from the traditional pricing structure to a new structure, even if the new structure would be more efficient in an aggregate sense. In such situations, the regulator may impose pricing restrictions that prevent Ramsey pricing or that impose a slower transition to Ramsey pricing than the operator would choose left to its own devices.

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