Universal service providers (USP) are increasingly active in business segments other than the segment consisting of their Universal Service Obligation (USO). Price regulation of USO services is usually cost-oriented and differentiated between USO- and non-USO-products. Hence, regulatory rules on cost allocation impact regulated prices and overall welfare. In this paper we analyse the effect of various cost allocation rules on the financing of USO, assuming a profit regulation in place. We use a stylized model with a set of products characterized by different price elasticities perceived by the USP. The model is calibrated for a scenario representing the postal market in industrialized countries. As a benchmark, we derive a welfare optimal allocation of costs based on Ramsey prices such that the incumbent USP breaks even. We then compare this result to cost allocation rules applied in practice: Fully distributed cost based on activities (ABC), and cost allocated according to a net cost rebalancing (NCR) mechanism. Under NCR, a regulated USP is allowed to reallocate the net cost of the USO through internal transfer payment. We find that cost allocation rules strongly affect prices and welfare under price control. NCR increases welfare clearly as compared to ABC.
