Professor,What do you
mean by the term
“regulatory dilemma”
I refer to the dilemmaconfronting regulators
(e.g., public service commissioners) as
they go about the task of subjecting firms
coveredby their legislative mandate to rate-of-return regulation.
We will use some simple graphs toillustrate that marginal cost pricing
will, in the case of sustainable natural monopoly, saddle the regulated firm with losses. The Courts have ruled
that the regulated firm must receive a return on shareholder equity that is
“fair.”
MWHs
$
0
MR
LAC
LMC
PM
QMQC
CM
Case 1: Unregulated Monopoly
D = AR
MWHs
$
0
LAC
LMCMR
D = AR
Case 2: Marginal Cost Pricing
QC
PC
C1
Recall the necessary condition
for socially efficient resource
allocation: P = MC
Hence:
•Option 2 is optimalon social efficiencycriteria.
•Why not select option2 and subsidize the regulated firm by amountC1PC? Subsidies give rise to problems of
distributional equity. For example, supposethat gas companies were subsidies from general
tax revenues—does this not amount to an income transfer to gas customers from tax
payers that areall electric”?
MWHs
$
0
LAC
LMCMR
QA
PA
Option 3: Average Cost Pricing
Option Price Quantity
Dead Weight Loss
given by area
EconProfit given by
area
1 PM QM PMCM
2 PC QC 0 (C1PC)
3 PA QA 0
Comparing the results
In summary, option 2 is superior on social welfare grounds—but fails to
produce a fair return for the regulated firm. Option 1 certainly gives the regulated firm a
hefty return, but fails badly on welfare grounds. Option 3 is a “compromise”and is best in terms of reconciling two
objectives—i.e. maximization of the total surplus
and the necessity to provide regulated firm a fair return
