Economics of Tariff Design

Before identifying situations in which tariff design should be left to the operator, it is important to examine the objectives of the operator and the objectives of the government. Here, it is assumed that the operator wants to maximize profit¹ and that the government’s interest in tariff design is to maximize welfare and provide affordable service to the poor. Welfare is the difference between the value that customers place on the service and what it costs to provide the service.² The operator and the government also have an interest in maintaining a stable political environment, but they may disagree on the role of regulation in that environment. As a result, the operator and government may disagree on issues such as service to the poor, which are generally viewed more as social policies than as economic policies. The operator and the government may also disagree on price discrimination, the situation where different customers pay different prices even though the costs of serving these customers are the same. The operator may find that some forms of price discrimination increase profit. However, customers generally do not like price discrimination on grounds of fairness, so the government may want to limit what is generally called undue price discrimination.

To maximize profit, the operator seeks prices that equate marginal revenue and marginal cost, which, properly estimated, consider the need for a politically sustainable business and regulatory environment.³ Marginal revenue is the extra revenue the operator receives when it increases output by one unit. Once marginal revenue and marginal cost are equal, any change in output decreases profit, so the operator is making as much profit as it can on the service in question.

When markets are perfectly competitive, marginal revenue is equal to the market price. As a result, the profit-maximizing operator in a competitive environment will charge prices that are equal to marginal cost. Marginal cost pricing also maximizes welfare, so the interests of the operator and the interests of the government coincide when markets are highly competitive.

Footnotes

1. The references section for Basic Financial Statements and the reference section for Asset Valuation Techniques describe how to measure profits.
2. Welfare includes both the net benefits to customers and the net benefit to the operator that come from the service being provided and used. The net benefit to customers is called net consumer surplus and is the difference between the value that customers place on the service – more specifically, the area under the customer demand curve – and what customers pay for the service. The net benefit to the operator is called profit and is the difference between the revenue the operator receives and the costs the operator incurs. Sometimes the government may value net consumer surplus more or less than it values profits, in which case welfare is a weighted sum of net consumer surplus and profit. Welfare is generally maximized when prices equal their respective marginal costs. Marginal cost includes the all of the extra costs that the operator incurs when it increases output by one unit. If the system is capacity constrained, meaning that capacity cannot be increased, marginal cost would also include the marginal congestion cost.
3. The reference section for Principles, Options and Considerations in Rate Design and the reference section for Economics of Alternative Price Structures provide information on economics of pricing.