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Optional Two-Part Tariffs: Toward More Effective Price Discounting

Fortnightly Magazine - July 1 1997


Ronald Rudkin is vice president with Analysis Group Economics and head of the firm's utility consulting practice. He has 15 years of experience with the Southern California Gas Co. He has testified before the California Public Utilities Commission, the California Energy Commission and the Federal Energy Regulatory Commission. David Sibley is the John Michael Stuart Centennial Professor of Economics at the University of Texas at Austin and is an authority on utility pricing. He is co-author of The Theory of Public Utility Pricing. He has testified on energy pricing matters before state commissions in Texas, New York and Massachusetts.

Economic Principles and Tariff Design

Optional two-part tariffs allow utilities to stimulate demand by moving energy charges closer to marginal cost. Stimulating demand increases the size of the economic pie, benefitting both shareholders and ratepayers. This strategy also will minimize the discount required to retain at-risk customers with access to competitive alternatives.

Figure 1 shows a demand curve for an individual customer. At a price P0 the customer would buy Q0 units. P0 represents the best alternative available to the customer. This could be either the utility's base tariff or the competitive alternative available to the customer. However, notice that for all units less than Q0 the amount the customer would have been willing to pay exceeds P0.

Figure 1

The triangular area above the price level but below the demand curve is a measure of the benefit the customer receives from buying Q0 units for P0. Economists refer to it as consumer surplus.

The rectangular area between the price, P0, and marginal cost, MC, is referred to as producer surplus. It represents the sum of net benefits to the producer associated with each incremental unit sold, where the incremental benefit is the difference between price and the marginal cost of providing each unit.

By assuming that P0 is usage rate associated with the utility's standard tariff, an optional two-part tariff can be designed that benefits both the consumer and the utility. Suppose that the utility designs an optional two-part tariff with access charge A1 (equal to the base quantity, Q0, multiplied by

P0 - P1) and usage charge P1 (see Figure 2).

If the consumer selects the optional tariff, then his or her CS will increase by A2. The lower usage rate, P1, induces the consumer to increase consumption from Q0 to Q1, so the new CS is the triangular area above P1 less the access fee, A1. Producer surplus increases by A4. In effect the total economic "pie" grew larger as the usage rate moved closer to marginal cost, enabling both customers and shareholders to benefit.

Figure 2

However, the utility can do even better. Instead of setting the usage price equal to P1, the utility could set the usage charge equal to marginal cost, MC, and the access charge equal to A1 + A2 + A3 + A4 + A5. Doing this will produce the same consumer surplus as the base tariff or the competitive alternative, but will increase margin contribution (compared to the optional tariff shown in Figure