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Revenue Caps or Price Caps? Robust Competition Later Means Healthy Choices New

Fortnightly Magazine - May 1 1996

before. Further, the industry becomes less efficient, as well as more profitable under certain conditions. The industry's overall performance also moves closer to an environment in which individual firms possess market power.

Figure 2 (see sidebar on page 32) illustrates the effects of a revenue cap imposed on a declining-cost electric power industry. As in the previous scenario: 1) consumers are worse off, 2) total economic welfare declines, 3) prices move farther from marginal cost, 4) average cost rises, and 5) the utility enjoys higher profits in the amount of the reduced costs.

A cap set below prior revenues (as in Figure 1) produces fairly similar results (em although the utility's profits may not increase. In other words, these adverse

outcomes hold true even when consumers pay lower bills and the utility faces lower total costs.

Flawed Diagnosis?

Clearly, a reduction in total

bill and total costs does not, as revenue-cap advocates claim, also ensure progress toward social or regulatory objectives. State regulators could inflict great harm on the general public by approving a revenue-cap plan, especially in a time of increasing competition in the industry.

First, total bill is a flawed measure of consumer benefits. Revenue caps presume that consumers always benefit when their electricity bills decline. Yet electricity consumers directly benefit from greater quantity and quality of electric service. Thus, a consumer with a lower electricity bill may actually receive lower net economic benefits from the consumption of electricity than other consumers.

Consumer welfare is properly measured as "consumer surplus" (em the value received from a product or service minus the expenditure outlay. For example, if price falls and the price elasticity of demand exceeds one, both the total bill and the consumer surplus would increase. Since consumers are undeniably better off when price falls, price, rather than total bill, correlates with consumer welfare. That is, all other factors remaining constant, an unbroken inverse relationship exists between consumer welfare and the price of a product or service. This relationship does not hold true between total bill and consumer welfare.

Second, revenue caps tend to produce higher prices than price caps or ROR regulation. Price-sensitive customers suffer because utilities become reluctant to offer discounted rates. As additional consumption increases total costs by more than total revenues, utilities find little incentive to offer prices that reflect actual market conditions.

In fact, utilities find clear disincentive to reduce prices for core customers or services (where the price elasticity of demand is less than one). Lowering price to increase consumption would increase total costs while reducing revenues, causing profits to decline. This result holds true even if the existing price exceeds marginal cost. In other words, revenue caps discourage utilities from expanding sales even under economical conditions (e.g., surplus capacity), because they truncate the marginal revenues actually received by the utilities.

Third, revenue caps convey improper price signals by widening the price/marginal-cost cap. When consumption falls, for example, utilities could increase price even though marginal cost falls or at least stays constant. The ability to raise prices when demand falls obviously runs contrary to