Cross-subsidization when Firms Are Allowed to make Non-zero Profits

Faulhaber's (1975) concept of cross-subsidization is of crucial importance for regulatory activities. Its basic idea that customers demanding a good should not pay more than they would if they "stood alone" is a fundamental fairness rule which can be applied by independent regulators in infrastructure industries. In reality, however, regulators frequently do not restrict the pricing policy of a regulated firm to zero profits due to the influence of politicians and pressure groups or, in the case of state-owned firms, because of a mandate to generate profits to reduce the state's budget deficit. They approve of prices generating positive economic profits. In this case, Faulhaber's (1975) concept is not applicable. We develop a less restrictive concept of cross-subsidization which can be applied when regulators are not independent and allow firms to make non-zero profits. We generalize the usual stand-alone and incremental cost tests to the case when regulated firms make positive profits, and provide an equivalence result for the (generalized) stand-alone cost (GSAC) test and the (generalized) incremental cost (GIC) test.