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Rate-Case Mania: Lessons for a New Generation

Fortnightly Magazine - February 2006

regulation (COSR). Consumption takes place at Q2, a lesser amount than would be consumed under marginal cost pricing. Compared to the first-best case, consumer surplus is lower and so is economic efficiency in resource allocation.

The third-best option is shown by point A. This lets the utility maximize its profits without any regulatory constraint. The firm will chose a price and quantity combination such that its marginal revenue (shown by the MR curve) is equal to its marginal costs. This is shown as point A on the demand curve, with a price of P3 and a quantity of Q3. Customers use a lot less than they would under a COSR or perfectly competitive market design and pay a lot more for it.

By pricing above marginal cost, the monopolist creates a large deadweight loss in economic efficiency and earns super-normal profits labeled as monopoly rents in the figure and shown by the colored rectangle.This represents a redistribution of gains from consumers to the monopolist. The purpose of regulation has been to eliminate these excessive profits. This most often has been accomplished by setting the price at P2. We have assumed in the discussion thus far that electric rates are single-part rates that are the same for everybody. There are indeed better ways to get from inefficient point B (where the single price equals average costs) to “better second-best” points closer to efficient point C (where the marginal price equals marginal cost). The challenge in rate design is to find some acceptable way to do this ( i.e., some combination of price discrimination and/or multiple-part tariffs).

In practice, the second-best output level is not Q2 at which average cost (AC) equals price, but is something substantially larger, obtained by selling additional units of output at lower prices. In principle, perfect price discrimination could increase output to the first-best optimal level Q1 at which the (marginal) price equals marginal cost. In practice, that is not possible, but in any real utility situation, it is certainly possible to do better than Q2. One of the major issues in designing electricity tariffs is deciding how much of what kind of price discrimination should be allowed, and for whom.

Prior to the 1980s, optimal regulatory outcomes were realized by COSR in North America and by public ownership of the electric utility in Europe and much of the rest of the world. COSR required regulators to perform a detailed review of utility fixed and variable costs of electricity generation, transmission, and distribution. This detailed approach to regulation is sometimes called “heavy-handed” regulation. It suffered from some notable weaknesses.

One problem was that it was not apparent how costs should be allocated across customer classes, since the same utility assets were used to serve all customers simultaneously. To deal with this problem, a variety of cost-allocation methods were developed that allocated costs across classes based, for example, on the share of each class in the system peak load.

A bigger challenge was the little incentive for the firm to lower its costs of production. The higher its costs