The Economics of Public Utility Regulation

By Blackstone, Erwin A.; Fuhr, Joseph P., Jr. | Atlantic Economic Journal, June 1989 | Go to article overview

The Economics of Public Utility Regulation


Blackstone, Erwin A., Fuhr, Joseph P., Jr., Atlantic Economic Journal


The Economics of Public Utility Regulation

I. Economics of Public Utility Regulation

Public Utility Regulation grew out of the market imperfection that economies of scale made it inefficient to have more than one firm in the industry. There is much controversy over how to regulate these natural monopolies and whether the gains exceed the costs of regulation. In theory, public utility regulation makes sense. The rationale is that an unregulated monopoly would not have to be concerned about entry of competitors and thus would be able to make substantial profits by pricing considerably above cost. This is due in part to the relatively inelastic demand for goods, such as electricity, telephone service, gas, and water. Thus, the goal of equity, namely, achieving a fair rate of return and a fair price, makes political sense. Also, rate of return regulation in theory will result in price closer to marginal cost. However, other methods of regulation have the potential to increase allocative efficiency even more.

Regulation, which developed because of market imperfections, itself has many imperfections. There are numerous costs of regulation and there are ways to circumvent the regulatory constraint and increase profits through vertical integration or over-capitalization. Although rate of return regulation may increase allocative efficiency, it can lead to decreases in X-efficiency (management and production) and dynamic efficiency (innovative) [Scherer, 1987]. Rate of return regulation is a cost-plus pricing system so that firms generally have little incentive to cut costs. Various proposals have been made for some type of incentive regulation, including most recently the social contract or price caps in the telecommunications industry. This article reviews the Crew and Kleindorfer book and in the process considers various issues in public utility regulation.

II. Equity and Efficiency

The efficiency and equity aspects of public utility regulation which Crew and Kleindorfer emphasize are examined first. From an economist's point of view, allocative efficiency is achieved when price equals marginal cost. Thus, to maximize net benefits in the traditional welfare function price should equal marginal cost, assuming that marginal cost pricing occurs in all other markets.

As Crew and Kleindorfer note, the second best theory analyzes net benefit gains when some markets are not pricing at marginal cost. Even if second best leads to marginal cost pricing, subsidization becomes an issue in decreasing cost industries. It should be noted that if average total cost exceeds marginal cost, a regulated firm forced to price at marginal cost will incur losses and eventually go out of business unless it receives a subsidy. This subsidy leads to two important questions: first, how X-efficient and dynamic efficient will a firm be when it knows that any deficit will be made up by the government; and second, should the government subsidize private enterprises? Public transit systems are an example of the X-efficiency problems which may result from subsidization.

Other options mentioned by Crew and Kleindorfer are fair rate of return, welfare optimal break-even pricing, and two-part tariffs. These options eliminate the subsidy requirement but decrease allocative efficiency. The fair rate of return option sets price equal to average total cost and involves no subsidy. As Crew and Kleindorfer mention, such pricing leads to inefficient allocation of resources.

In the multiproduct case, the regulated firm may price some or all products above marginal cost to cover total costs. The welfare break-even pricing employs an inverse elasticity rule to ensure the firm earns a normal profit. Each good is priced above marginal cost. Assuming the products are unrelated, the more inelastic the demand for the product the greater is the percentage mark-up above marginal cost.

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