Question

1.Explain why economists advocate that regulators use marginal-cost and not average-cost pricing. Also explain why regulators favor average cost pricing.

2. Provide the formula for how a Public Utility Commission determines the rate-of-return. Then relate it to the Averch-Johnson Effect.

3. Draw a graph that shows the social welfare loss from a flat rate as compared to using a peak and off-peak rate. Explain.

4. Why is it a challenge to utilities to promote energy efficiency? How might decoupling reduce the challenge?

Answer 1

Question: 1

Explain why economists advocate that regulators use marginal-cost and not average-cost pricing. Also explain why regulators favor average cost pricing.

Solution:

Explain why economists advocate that regulators use marginal-cost and not average-cost pricing.

Economists advocate that regulators use marginal-cost pricing rule because of attaining the economic efficiency to regulated utilities and also to achieve the efficient level of output in this method of regulation.

In the marginal cost pricing rule, the efficient regulated prices are set where MC curve intersects the Demand curve. In other words, P = MC and this price is lower than the Monopoly price. As a result of which higher level of output is attained.

But when regulators use this strategy to regulate a natural monopoly then that firm incur (experience) economic losses because MC < AC or P < AC. It can be covered only through the subsidies given by the govt.

Average cost pricing states that when a firm equate its prices to its average total cost or (P=AC).The regulators advocates more on Marginal cost pricing because if a natural monopoly is forced to charge a perfectly competitive price (using a marginal cost pricing rule), the firm will not be able to cover its costs. Even if the firm is allowed to price discriminate, it still might not be able to cover its losses. So average cost pricing is considered a second-best solution that it allows the natural monopoly to make a normal profit but does not allow it to set its price as high as it would were it unregulated.

Also explain why regulators favor average cost pricing

Average cost pricing generate a normal profit for Natural monopolist as P =ATC. This regulation forces the Monopolists to reduce the prices where firms ATC intersect the market Demand curve to increase in social welfare and efficient level of production. This method imposed on Natural or legal monopolies to attain the increasing return of scale.

A normal profit is not guaranteed in Marginal cost pricing rule because a firm incur losses due to P < AC. So, in natural monopolies (especially in public utilities) preference is given to Average pricing cost. This is the main reason regulators favor average cost pricing to natural monopolies.

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