Question

Consider an electric utility whose regulated price (tariff) for electricity is equal to its average cost. The utility has total revenue of $10 million per week. Because of weak incentives to keep its costs low, its average cost is 10 percent higher than the average cost that an efficient firm could achieve. The price elasticity of demand is estimated to be –0.4.

a) How much more total surplus per week could be achieved if the firm produced efficiently, and regulators set the price for the firm’s output equal to its new lower average cost? Explain your answer and illustrate your answer with a graph. Who would capture these benefits? …consumers, the regulated firm, both? b) Contrast your answer to part a with a case in which the firm lowers its costs, but regulators allow the firm to maintain its price at the original higher level. c) How would the comparison between parts a and b change if demand was price elastic, rather than inelastic? HINT – I’m looking for a qualitative answer here

Answer 1

Let electricity per week consumed be 10 million units As per the question Total Revenue(TR) is $10 million so price is TR/Q= $1 per unit.

Now this $1 is regulated price which is equal to to average cost of our firm.

However since our firm operates at 10% higher cost than an efficient firm the cost for the efficient firm would be $0.91.

Further as price elasticity is 0.4 it means for every 1% change in price quantity demanded (Q) changes by 0.4%.

a.) As per the question if our firm produces efficiently now i.e. at $0.91 rather than $1 before and the price is set at $0.91 then there is 9% fall in price. This raises Q by 3.6%.

Therefore new TR =10.36 * $0.91= $9.43 million.

This means TR has fallen because of price fall.

This is shown in the diagram below.

As can be seen from diagram there is rise in consumer surplus, fall in producer surplus and efficiency gains.

However as the good is price inelastic therefore price fall is captured by consumers.

Note: Due to price fall consumers benefit as this raises the consumer surplus (see the shaded region).The regulated firm produces more units of electricity than before due to efficiency however it gets lower prices than before.Thisprice fall is not compensated with greater or equal rise in quantity demanded so TR falls.

b.)Here our firm is producing efficiently at $0.91 but the regulator has set prices at original level i.e. at $1.

As there is no change in price so there is no change in Q.

Further TR is unchanged at $10 million but the cost for the firm is 10*$0.91= 9.1 million.

Therefore there is a profit of $0.9 million.

This means with no change in price firm earns profits due to efficiency.

If this is contrasted with a.) then consumer surplus is unchanged but producer surplus rises as it can operate now at lower costs.

c.) Suppose that price elasticity is greater than 1 or is price elastic.

This means with 1% change in price Q rises by more than 1%. If prices fall then Q would rise by larger amount thereby raising TR for our firm as now the consumers are price sensitive.

If power is generated at lower costs then consumption level increases leading to more profits for our firm.

P.S : Let me know if more explanation is required.