An Introduction to Economic Regulation

1
An Introduction to Economic Regulation
2
Rationales for Regulation

• Suppliers of essential inputs to other industries
• Natural monopolies
• Excess duplication or externalities
• Competition does not work well

3
Public Utilities in the U.S.

• Have an exclusive government franchise to serve a
  particular market under a particular set of
  conditions
• Government maintains the right to
• Control entry
• Regulate price
• Prescribe standards of quality and conditions of
  service
• Investment decisions
• Franchise bears the responsibility to serve all
  customers on terms deemed reasonable

4
The Demand for Regulation

• Misleading to suggest that regulation is always
  forced upon business by government
• Business has sought to be regulated
• Why would this occur?

5
The Legal Concept of the Public Interest

• Common Law
• The concept of common callings required that
  tradesmen who engaged in certain areas of
  activity accept the obligation to serve at
  reasonable prices
• Included roads, bridges, ferries, inns and pubs
  which were regarded as accommodations that were
  necessary for the convenience of the public and
  were affected with a public interest

6
The Legal Concept of the Public Interest

• Munn v. Illinois
• Involved a dispute relating to the Illinois law
  for licensing and operating grain elevators
• Supreme Court established the principle that
  where the public interest is involved the public
  interest may take precedence It may be lawful
  for the state to regulate private business

7
The Legal Concept of the Public Interest

• Munn v. Illinois
• Public interest concept established in Mann
  incorporated several concepts
• Businesses to which it would apply are those
  which affect the community at large
• Direct connection with common callings concept
• The presence of monopoly
• The principle of just price seems implicit in
  Munn
• when prices are excessive or arbitrary
  government regulation may be necessary and lawful
• Just price appears to be defined by cost not
  ability to pay

8
The Legal Concept of the Public Interest

• Munn v. Illinois
• Established a legal precedent of public interest
  consistent with the economic justification to
  control natural monopoly
• Need to regulate is derived from market
  imperfections which result in nonoptimal
  allocations of resources
• Regulation is aimed at improving efficiency

9
The Legal Concept of the Public Interest

• Nebbia v. New York
• Supreme Court held that it was entirely proper
  for the New York State legislature to define the
  public interest de novo - without being bound by
  precedent
• Legal concept no longer conformed to the economic
  concept

10
What should be regulated?

• Natural Monopoly
• When a single firm can provide a range of
  services or goods at lower total costs than a set
  of firms
• Typical example is production of a single
  commodity where LRAC declines for all outputs

11
Natural Monopoly
Cost,Price
LRAC
1
Marginal Cost
Demand
Q
12
Permanent and Temporary Natural Monopoly
Cost,Price
LRAC
1
D1
D2
Q
13
Permanent and Temporary Natural Monopoly

• Permanent LRAC falls continuously as output
  increases
• No matter how large the market is a single firm
  can produce at least cost
• Temporary LRAC declines up to a point and then
  becomes constant thereafter
• Can become workably competitive
• WHY?

14
Permanent and Temporary Natural Monopoly

• Examples
• Microwave telephone systems
• Consists of a number of stations that are 20 40
  miles apart that transmit signals of specific
  frequencies
• Each station requires land, a tower and antennas,
  electronic equipment and so on
• These inputs do not increase proportinately with
  the number of circuits as volume increases
  these costs are spread over more calls

15
Permanent and Temporary Natural Monopoly

• What about technological change?
• Cost function will shift as new knowledge is
  incorporated into the process
• Implies permanent natural monopoly is a rare
  category

16
What is the Public Policy Dilemma with Natural
Monopoly?

• How can society benefit from least cost
  production
• Requires single firm
• At the same time, how do you prevent monopoly
  pricing?

17
The central issue of regulatory economics

• design mechanisms that regulators can apply to
  induce firms to achieve optimal outcomes.

18
Natural Monopoly
Cost,Price
Marginal Cost
Average Cost
pM
Welfare loss
Excess Profits
pac
pmc
Demand
MR
Qac
Qmc
QM
19
Key tasks

• The desired outcome must be characterized
• the incentives embodied in the regulatory
  mechanism should induce the regulated firm to act
  in a way that results in this outcome.

20
One Alternative - Profit Maximization

• Profitability Rate of Return
• (Total Revenue - Total Cost)/Invested Capital
• Net Income /Invested Capital or
• Net Income / Investors equity

21
The goals of regulation

• In theory, regulation seeks the outcome that
  would occur in an ideally functioning market
• In practice, local or central governments require
  suppliers to guarantee access on fair terms.

22
The obvious question is

• What defines fair??

23
Smith v. Ames (1898)

• The court declared that a company supplying a
  public service might not be denied an opportunity
  to charge rates that would yield a reasonable
  rate of return on the fair value of its property
  devoted to the public service
• Qualified by the consuming public has a right to
  enjoy service at rates no higher than what the
  service is reasonably worth

24
From the investors perspective

• Pricing at fair rates can impart significant
  risk
• after they have sunk their capital they will be
  limited in the prices they can charge and
• they could be subject to possibly onerous
  obligations to serve and to guarantee security,
  stability and safety.

25
Incentive to invest

• Depends critically on the expectations that the
  future pricing policy will be sufficiently
  remunerative to justify the investment.

26
The Objective of the Regulatory System must

• Command the support of consumers and investors
• provide sufficiently remunerative prices to cover
  costs and enable investment to be financed
• provide incentives for the utility to provide a
  reasonable quality of service and to produce the
  good or service at low cost

27
So this means

• We have to define
• how prices are to be determined
• what are enough revenues
• how do we define costs
• what is a reasonable quality of service
• what is a fair return

28
How are prices determined

• Establish the Revenue Requirements
• R Expenses s(RB)
• where
• R is equal to the sum of piqi
• s is the allowed rate of return
• RB is the ratebase which is a measure of value of
  the firms investment

29
Test Year Revenue Requirements
30
Pricing the Service

• The difference between utility rate setting and
  the pricing of other commodities reflects the
  difference between two kinds of markets
• utilities tend to be free of competition by other
  suppliers - rates are administered
• competitive prices result from the interaction of
  supply and demand

31
Pricing Utility Services

• Rate Design
• Regulators design rates using the costs incurred
  by each class as well as other non-cost
  attributes
• Rates always are adjusted in some manner for
  reasons such as impacts on certain customer
  groups, adequacy (too rich), revenue stability
  (utility is not accepting enough risk), rate
  continuity, (phase in the increase) and
  simplicity.

32
General Agreement that Prices should reflect costs

• The question is what costs?

33
Controversy over the use of Average Historic vs.
Marginal Costs

• The controversy tends to turn on the distinction
  between equity and economic efficiency
• some how fair is viewed as the mechanical
  division of historic costs among user so that
  revenue requirements is the sum of the parts
• Economists prefer economic efficiency

34
Objectives of Rate Design

• Achieving the Revenue Requriement
• Economic Efficiency
• Simplicity and administrative ease
• conservation of resources

35
Objectives of Rate Design (Cont)

• Fair apportionment
• Stability and gradualism
• Social goals
• Environmental Protection

36
Averch-Johnson Effect

• A-J effect states that firms which maximize
  profit subject to a rate-of-return constraint
  choose too much capital relative to other inputs
• One might argue that the A-J effect has
  stimulated innovation

37
Regulatory Lag

• The tendency of regulated rates to adjust slowly
  to changes in cost
• causes the actual rate of return earned by the
  utility to diverge from the commission determined
  fair rate of return
• when prices are fixed utilities can earn a profit
  by cutting costs WHY?

38
Alternative Approaches to Incentive Regulation

• The Sliding Scale
• Price Caps
• Yardstick Approaches