Once the overall price level has been established for the operator, the work of establishing the rate (or price) structure still remains. This work is called tariff design1 or rate design and refers to relationships among the individual prices (or rate elements) that the operator charges. In some instances, the regulator may choose not to regulate the price structure. Examples include (1) situations where the objectives of the operator are in line with, or at least do not contradict, the objectives of the regulator, at least as they relate to rate design, and (2) situations where the regulator’s resources are limited and regulating price structure is a low priority.
Most economists agree that efficient price structures cover total cost and align prices with marginal costs. Marginal cost is the additional capital and operating cost that results from increasing output by a single unit.2 Marginal cost pricing may be difficult in situations where there are economies of scale or economies of scope because prices equal to marginal costs would not cover all of the costs of the operator and thus would not attract investment. In these situations, regulators and operators generally favor multipart pricing or in some instances Ramsey pricing.3 Multipart pricing is an arrangement where the operator charges separate prices for different elements of the service. For example, a water provider may charge a connection fee plus a usage fee. With Ramsey pricing, which is also called differentiated pricing or the inverse elasticity rule, the operator charges higher prices to customers with inelastic demand and lower prices to customers with elastic demand.4
- Tariff Design covers this practice in depth.
- If the system is capacity constrained, meaning that capacity cannot be increased, marginal cost would also include the marginal congestion cost.
- Regulators generally limit the use of Ramsey pricing to services that are not considered basic or essential to customers the regulator is particularly trying to protect, such as low income or residential customers.
- Customers have inelastic demand if they do not change the amount they purchase by very much if the operator changes its prices. Conversely, customers have elastic demand if they respond to changes in prices by making large changes in the quantities that they purchase. More precisely, inelastic demand means that a one percent change in price results in a percentage change in the quantity demanded that is less than one percent, while elastic demand means that the one percent change in price results in a greater than one percent change in quantity demanded.