What procedures should the regulator adopt in order to balance economic and social objectives (like efficiency vs. fairness)?

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[Response by Sophie Trémolet and Diane Binder, June 2009]

In a perfectly competitive environment1, both economic and social objectives are achieved when tariffs are set at the marginal cost of provision. Indeed, social objectives are to maximize the welfare2 of consumers, i.e. to maximize the difference between the value they place on the service and the cost of service provision. Welfare is therefore maximized when service is provided at marginal cost. Economic objectives are met when operators can maximize their profits: in a perfectly competitive environment, operators will charge prices equal to marginal costs. In such a case, social and economic objectives are aligned. In addition, tariffs set at the marginal cost of provision lead to a more efficient use of the service.

However, operators providing utility services have certain cost characteristics that make them a natural monopoly. In a monopoly situation, profit-maximizing prices charged by operators need to exceed their marginal cost of provision, in order to recover the amount of capital sunk in the first place so that the operators can be commercially viable3.

Since allocatively efficient pricing is not possible, Ramsey Pricing offers a second-best solution, where individual prices would be raised above marginal costs according to the service’s price elasticity of demand. That means that operators would have certain price flexibility within service baskets4 defined by the regulator, and that certain types of customers (those whose demand is said to be more inelastic) would pay a higher mark-up above marginal cost than another type of customers.

Whereas this price structure would be more efficient economically in an aggregate sense, Ramsey Pricing raises issues in terms of fairness. Customer groups with relatively inelastic demands (which often means without substitutes) will pay a higher price, which is against the principles set by a regulator. Furthermore, some customers with relatively inelastic demands may acquire a strong incentive to seek alternatives if charged higher markups, thus undermining the approach. Politically speaking, customers with relatively inelastic demands may also be viewed as those for whom the service is more necessary or vital; charging them higher markups can be challenged as unfair or socially undesirable5.

Targeted subsidies with lifeline rates and connection subsidies may be a better way of reconciling efficiency and fairness, with minimal losses in terms of efficiency6. Connection subsidies would give an incentive to operators to expand services at cost in areas where capacity to pay of customers would usually not meet the capital and operation cost requirements. Targeted subsidies to low-income consumers can combine economic and social objectives7.

 

Resources

Understanding Regulation: Theory, Strategy, and Practice
New York: Oxford University Press, 1999, Chapter 15.
Baldwin, Robert, and Martin Cave

The Economics of Regulation: Principles and Institutions
Cambridge, MA: MIT Press, 1988, Reissue Edition, vol. I, Chapter 5 and vol. II, Chapter 4.
Kahn, Alfred

Basics of Rate Design – Pricing Principles and Self-Selecting Two-Part Tariffs
in Infrastructure Regulation and Market Reform: Principles and Practice, edited by Margaret Arblaster and Mark Jamison. Canberra, Australia: ACCC and PURC, 1998, pp. 74-90.
Berg, S.

Expanding Water and Sanitation Services to Low-Income Households
Note no. 178 in Public Policy for the Private Sector. Washington, D.C.: World Bank Group, 1998.
Komives, Kristin, and Penelope J. Brook Cowen

Impact of Market Structure on Service Options for the Poor
Presented at Infrastructure for Development: Private Solutions and the Poor, 31 May – 2 June 2000, London, UK.
Ehrhardt, David

Footnotes

  1. See “competitive conditions” in the glossary.
  2. See “economic welfare” and “social welfare” in the glossary.
  3. See Monopoly and Market Power.
  4. Sub-markets subject to similar degree of competition (Ed.).
  5. See Deviations from Marginal Cost Pricing: Ramsey Pricing.
  6. See What are the strength and limitations of lifeline rates? for discussions on the strength and limitations of lifeline rates.
  7. See What should regulators do to meet social objectives set by policy-makers? about meeting social objectives and Do higher income customers benefit more from subsidies than do poorer customers? about the importance of targeting subsidies.