Academic journal article Contemporary Economic Policy

Politically Feasible, Revenue Sufficient, and Economically Efficient Municipal Water Rates

Academic journal article Contemporary Economic Policy

Politically Feasible, Revenue Sufficient, and Economically Efficient Municipal Water Rates

Article excerpt


Objectives of municipal water rate design include economic efficiency of water use, revenue sufficiency, and related revenue stability, although it is commonly accepted that these objectives cannot be achieved simultaneously, requiring trade-offs among the objectives (American Water Works Association, 2000). A numerical example herein illustrates these objectives for residential water rate reform and another objective for political feasibility.

Water utilities are an example of natural monopoly, characterized in classic textbook fashion with declining long-run average cost (LAC) above long-run marginal cost (LMC). As urban population grows over time, municipal water utilities reach the capacity of their existing system and look for new sources of water typically more expensive than system average cost. The numerical example presented here shows a declining LAC curve with discontinuities at the capacities of each additional water supply project. Each additional project provides water at higher cost than the previous project, but LAC is declining within the capacity constraint for each project. For natural monopolies, long-run incremental cost pricing is economically efficient but results in monopoly profit, overturning the conventionally accepted outcome that with "increasing returns to scale, marginal cost pricing leads to (revenue) deficits" (Renzetti, 2000).

For the case of natural monopoly with LMC less than LAC, the solution to revenue sufficiency is two-part pricing (Coase, 1946), with a "volumetric" (or "commodity") charge equal to marginal cost and a "customer charge" (or "connection fee") to collect sufficient revenue, assuming meters exist that measure each customer's water use. The numerical example presented here reverses this result; for a natural monopoly with LMC greater than system average cost, the two-part pricing solution sets the commodity charge equal to LMC and includes a rebate (or negative customer charge) to avoid monopoly profit. As an alternative to a negative customer charge, Los Angeles (LA) implemented a two-tier rate design with an initial lower tier price up to a threshold quantity of water consumed, and a higher LMC second-tier price for consumption above the threshold quantity, as illustrated in the numerical example.

Two problems with an increasing, two-tier rate design (or with a high LMC commodity charge and a rebate) arc revenue instability and political infeasibility. The cost structure that determines the revenue requirement includes large sunk costs and low variable costs. With a high commodity charge given by the second-tier price, variation in demand causes revenues to vary out of sync with the revenue requirement and may necessitate repeated, time-consuming, politically difficult, and costly rate hearings in order for the utility to meet the revenue requirement. This article presents a solution to revenue stability adopted by LA by regularly adjusting the initial tier price to maintain sufficient revenue.

Rate reform that switches from a lower to a higher LMC commodity charge redistributes consumer surplus from large water consumers to small water consumers and may not be politically feasible. The concept of political feasibility is formally defined in Hall (2009). Political feasibility in some urban areas and developing countries entails special consideration for low-income consumers and in other circumstances simply reflects the political power of competing interests. In the case of LA, rates were modified by creating multiple, homogeneous subgroups of residential customer classes with different thresholds, and adjusting each threshold amount between the two-tier prices so that each subgroup on average paid an amount similar to other subgroups for water, a solution considered equitable by enough members of the city council to approve the rate design. The numerical example illustrates such politically feasible water rates. …

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