In certain instances, regulatory schemes that incent the operator to decrease costs also incent the operator to lower service quality1. This may be especially true for access sold to rivals because the operator not only saves costs of quality, but the lower quality access also decreases competitive pressure. The regulator may respond to these incentives by regulating service quality. Such regulations may take the form of minimum standards, rewards for improving quality, and penalties for substandard quality. Regulating service quality involves the steps of identifying the preferred level of service quality, designing a system for providing the operator with the incentive to offer this service quality, and developing a system for monitoring service quality and enforcing the standards.
The preferred level of service quality should reflect the value customers place on quality and the operator’s cost of providing service quality. The appropriate level of quality equates marginal benefit and marginal cost.2 In principle, the marginal benefit should be the marginal benefit to the average customer. This is difficult to determine in practice, but regulators nevertheless attempt to learn customer quality preferences through survey instruments, the complaint process, benchmarking studies, and choice of quality options. It is generally preferred that preferences be aggregated into a few indices that reflect the tradeoffs that customers make between various dimensions of service quality. This allows the operator to make economic tradeoffs when trying to achieve the preferred level of customer satisfaction in the least costly way. A customer tradeoff in service quality might be that the customer places more value on the purity of water than on consistent water pressure. The relative importance of these two dimensions of service quality would be reflected in their relative weights in the aggregate index. With respect to cost, the operator may find that achieving an incremental improvement in water purity is very costly, but that an incremental improvement in water pressure is inexpensive. The operator can offer customers and optimal balance of cost and quality if the operator has the flexibility to make production choices.
In some situations, it may be optimal for operators to offer grades of service, so that each customer can choose the service quality that best serves her need. This approach overcomes the need to identify the marginal benefit for the average customer because individual customers reveal their preferences in the purchasing choices that they make. The levels of quality offered and the prices charged should reflect both the marginal costs of quality and differences in customers’ quality preferences. Price differences will generally be greater than the differences in marginal cost. If the operator failed to deliver the promised quality, customers would receive a refund based on the price paid and the price that would have been paid for the lower quality level, if the customer had chosen it.
Regulators can economize on costs of regulating service quality by monitoring a small number of quality indicators on a regular basis. These indicators may be sufficient for determining whether there is a quality problem. Once a problem is indicated, a more thorough analysis, including collection of additional data, can be done.
The enforcement of service quality standards commonly occur annually or at price reviews, but other options are available. If quality is a problem, frequent monitoring may be in order because waiting to address the problem until the next price review might allow the problem to persist too long.
Penalties for low service quality should reflect the customers’ loss of value. Conversely, rewards for exceeding service quality standards should reflect customers’ gain in value. (Where feasible, offering customers a menu of options eliminates the need to quantify penalties and rewards.) Publishing statistics of operator performance can provide a powerful incentive to meet quality standards, especially if there is competition. This can be particularly useful when services take on the characteristics of what economists call experience goods, which means that customers cannot determine service quality unless they actually purchase and use the service. Publishing service quality monitoring results lets prospective customers learn what existing customers experience and make effective choices among service providers in situations where customers have competitive choices.
In some situations poor customers cannot afford cost-based prices for service that is equal in quality to that purchased by the general population. Regulators sometimes respond to this situation by allowing the operator to offer lower quality services to poor customers. Operators choosing this approach may find it profitable to serve poor customers, which would make both the poor and the operator better off. Social Aspects in the references contains information on pro-poor policies. Tariff Design’s section on Pricing for the Poor provides information on pricing for the poor.