Solution:

Ramsey Pricing:

• If an enterprise has common costs, marginal cost pricing may not be feasible.

• Ramsey pricing is the a second-best alternative that allows the firm to recover its cost while minimizing the adverse effects of allocative efficiency.

• It applies to public utilities or regulation of natural monopolies, such as telecom firms. 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 taking steps to ensure that the extent to which the 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 baskets of services that are subject to similar degrees of competition and allowing the operator price flexibility within each service basket.

• Even though Ramsey pricing can be economically efficient, it may not be consistent with the government's the 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 basket. In the case of services to the poor, the regulator may place upper limits on the prices.

• Lastly, regulators often note that Ramsey pricing is a form of price discrimination - although not necessarily a bad form of price discrimination - and customers sometimes object to it on that basis.

• The public sometimes believes that it is unfair to cause one type of customer to pay a higher mark-up above marginal cost than another type of customer.

• In such situations, regulators may further limit an operator's ability to adapt Ramsey prices. Practical issues exist with attempts to use Ramsey pricing for setting utility prices.

• It may be difficult to obtain data on different price elasticities for different customer groups. Also, some customers with relatively inelastic demands may acquire a strong incentive to seek alternatives if charged higher markups, thus undermining the approach.

• Politically speaking, customers with relatively inelastic demands may also be viewed as those for whom the service is more necessary; charging those higher markups can be challenged as unfair.