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Optional Two-Part Tariffs: Toward More Effective Price Discounting

Fortnightly Magazine - July 1 1997

month with an average of $50,900 per month. The standard deviation of the access charges is $16,900 per month.

With conservative price elasticity assumptions, offering optional automatic tariffs to core customers increases margin collection by $3.2 million/year (3 percent). To illustrate what would happen under higher and potentially more realistic assumptions, we increased the price elasticity assumptions to 0.5 for both the peak and off-peak periods. With the higher price elasticity, offering optional automatic tariffs to core customers increases margin collection by $7.4 million/year (7 percent).

Potential Obstacles

Regulators and competitors may challenge the introduction of optional tariffs for several reasons. First, regulators may be reluctant to allow utilities the flexibility to modify the optional tariffs on short notice, arguing that optional tariffs should receive the same level of scrutiny as the base tariff. Although this could happen, regulatory precedence exists for allowing utilities the flexibility to update optional tariffs with little notice. Telecommunication utilities are allowed to do this for residential and business customers as long as the tariffs satisfy the requirements of the Federal Communication Commission's Optional Calling Plan Guidelines. Many states allow utilities to offer flexible-pricing options designed to retain customers with competitive alternatives. %n4%n

Moreover, Niagara Mohawk Power Corp. has been granted permission to offer optional tariffs to both core customers and customers with competitive alternatives; and several utilities, such as the Southern California Gas Co., Boston Gas Co., Southern California Edison Co., and Pacific Gas and Electric Co. have either requested or have been granted authority to offer optional tariffs or flexible pricing options in addition to their base tariffs.

Second, regulators may be concerned that utilities will use optional tariffs to engage in anti-competitive practices. The usual concern is that utilities will price below marginal cost in an attempt to limit competition. This concern is usually dealt with by requiring utilities to set usage charges above marginal cost. %n5%n

Third, it is to be expected that competitors will spend considerable effort attempting to block the introduction of optional tariffs. The usual argument is that allowing monopoly-pricing flexibility will somehow limit competition, or disadvantage core customers. It has been our experience that the economic merits of optional tariffs (e.g., increased economic efficiency, minimization of the discount required to retain customers and reduction in the chance of uneconomic bypass) are sufficient to counter these challenges.

Fourth, regulators may be concerned that customers could be made worse off if they select the wrong tariff. While this can happen, allowing them to switch freely among the various tariffs offered by the utility can minimize the adverse consequences of customer mistakes.

Finally, it is sometimes argued that optional tariffs require inputs that are difficult to estimate and that these inputs are not required under traditional cost-of-service ratemaking. While it is true that optional tariffs do require knowledge of price elasticities, marginal costs and competitor costs, these inputs are required to price products in a competitive environment. The fact that traditional COS principles do not require these inputs would suggests that COS principles may be of limited usefulness in a competitive open-access