Question

In the Davis & Muehlegger (2010) analysis of pricing above marginal cost under regulation, they observe that ... decreased consumption along the intensive margin is not costly from the regulated firm’s perspective because the rate base does not depend on the level of natural gas consumption per customer. In short, under traditional rate-of-return regulation a reg-ulated firm attempts to maximize the rate base, and this creates incentive for firms to lobby regulators for low fixed fees.” (p. 803) In 2-3 sentences, explain what they mean, based on their analysis. Why does traditional ROR regulation provide this incentive?

Answer 1

There are innate flaws in the traditional rate of return regulation. We know that the firms are expected to acquire monopoly power and regulated by the government agency. The regulation can result in average cost pricing on marginal cost pricing.

When average cost or marginal cost is used as a price then there is no profitability. The firms reduce the cost of the production in order to get the profitability but these firms realize that how much low their cost goes, price will be fixed at that level. Hence there is no incentive to reduce cost.

This leads to the firm choosing an unprofitable or wrong mixes of inputs. They tend to misreport costs to the agency o as to show inflated revenues.

Under this system of traditional rate of return regulation, the firm will try to maximize their revenue which is possible only when the fixed fee is kept low and per unit charge is increased. To attract more consumers, implying maximizing the rate base, it is necessary to keep the fixed cost low and hence, under traditional rate of return regulation, firms will lobby the government to keep the fixed fee low and increase the per unit charge.