Features Of Public Utility Economics - Term Paper Example

Features Of Public Utility Economics Negative Externalities A negative externality is any cost or harm that is borne by a party not associated with a transaction. Essentially negative externalities are a shifting of costs from the producer to a third party. The effect of a negative externality is that the price of the product or service does not take these additional costs into account. Negative externalities are market inefficiencies as they distort the equilibrium price and quantity of a good or service. This distortion in price acts upon the supply curve because it falsely prices the total costs of production. Acid Rain Two examples from the utility industries are acid rain and smog from coal fired power plants. Acid rain is caused when power plants release sulfur dioxide into the atmosphere. Sulfur dioxide is a natural product of the combustion of certain types of coal. When the emissions enter the atmosphere they are transported by weather patterns. When the sulfur dioxide mixes with the water particles in clouds it increases the acidity level of the water. When the water condenses and falls back to earth as rain. The acid rain had various effects including destruction of crops, wearing away limestone buildings, acidification of open water sources, and health problems. The parties effected by the acid rain were often hundreds or thousands of miles away from the source of production. Smog Smog production begins much the same way as acid rain. Pollution is emitted from a power plant or other combustion engine and are released into the atmosphere. The particles of the emissions often condense and concentrate near ground level causing a yellowish brown fog of pollution in areas where it concentrates. Smog high smog levels are linked to low air quality, increased respiratory illnesses and can be dangerous to breathe for sensitive groups. The costs from this come in the form of decreased quality of life and increased costs for medical treatments. I will use these two examples throughout the discussion of the causes, effects and regulatory solutions to negative externalities. Causes and Challenges. The costs associated with a negative externality would normally have been paid for by the producer but are instead shifted to an outside party. This means the cost of production is not adequately accounted for by the producer of the product. These lower costs cause the good or service to have a lower marginal cost, effectively increasing the competitiveness of a firm compared to those without the externality. This lower marginal cost creates in incentive for overproduction and overconsumption. The incentives for overproduction and consumption are particularly problematic in cases like acid rain and smog. The plants that produce the acid rain and smog as a result of their production activities may be hundreds of miles away from the consumers as well at those suffering the costs of the externality. This means there will be little incentive to the producer to change its behavior as the harm is effectively externalized. Graphically this would be represented by a shift in the supply curve. If Negative externalities are present, the supply curve shifts to the right from a market efficient equilibrium. This decreases the equilibrium per unit price and increases the equilibrium quantity produced. The increase in the amount produced because of the artificially lowered price is called the over allocation. The decrease in the price is the amount of the spillover costs. Competition and Negative Externalities Competition has challenges in mitigating negative externalities for three reasons. First, there is a perverse incentive to externalize costs in a competitive market place. Second, externalities do not change the consumer’s incentives. Lastly, the structure and nature of public utilities often naturally limits competition. In a competitive market place there is an incentive to externalize as many of the costs of production as possible. The firm that is the most effective at externalizing costs lowers its cost of production and can therefore underbid its competitors that bear the full cost of production. In a commodity market like electricity, where one unit of electricity is the same as the next the only thing that companies can effectively compete on is price. This leads to the second problem with externalities, consumer incentives. Consumers who buy a product or service that has an externality have no market incentive to pay a higher price. The purchaser is not bearing the additional cost in health or quality of life, so the rational choice is to choose the cheaper product from amongst perfect or near perfect substitutes. Lastly, the market structure of most public utilities discourages competition from taking place to begin with. Many public utilities are natural monopolies. A natural monopoly occurs when it is inefficient for more than one provider to exist and entering a market is cost prohibitive. If more than one power provider wanted to compete for the business of a small town, they would either have to rent the use of the existing infrastructure, which would damage their ability to compete on price or install their own infrastructure which would in general be cost prohibitive and therefore provide a significant barrier to entry into the market. Solutions and Mitigation by Regulation. Although competition is often ineffective at correcting negative externalities, regulation has had success and offers several solutions both market oriented and result oriented. The basic premise of using regulation to correct negative externalities is to shift the costs from the third party back to the producers. Regulatory solutions can be broadly divided into two categories: market centered or direct intervention. Market centered options encourage types of competition that let market mechanisms price externalities, while direct intervention seeks to intervene in the market and either impose an additional cost on the producer or directly regulate what is produced. Market Centered Approaches Under market centered approaches, regulation seeks to let the market set an acceptable price for the externality. The three market centered approaches most commonly used are bargaining, litigation and markets for the externality. In bargaining the community or individuals most impacted by the externality will attempt to come to an arrangement with the producer of the externality. This type of bargaining is most effective when there are small numbers of producers and small numbers of people impacted by the externality. This type of solution also lends itself well to fixed investment type solutions like air scrubbers. The community may agree to pay for part of the upgrades in order to incentivize the plant to implement the changes. The second type of market based approach is for those harmed by a negative externality to sue the producer for the harm that they have caused. This can work on two levels. First those harmed by the externality can be compensated. Secondly, punitive and exemplary damages can be awarded in order to incentivize a change in policy. The last market based approach I will discuss is the creation of markets for the externality. This is often called a cap and trade approach. The government sets a limit on the amount of the externality that can be produced and then allocates certificates to the producers and allows the producers to buy and sell the certificates on an open market. Over time the cap is lowered. This provides an incentive for companies to reduce externalities more quickly in order to sell those reductions to others, it also forces those who over produce to pay for that ability. This is the approach that was taken to eliminate most sulfur dioxide emissions which effectively ended the problem of acid rain in the United States. Direct Intervention Direct intervention can take two forms, direct control or taxation. Under direct control either the amount of production is limited or the price that a good or service can be sold for is regulated. This type of intervention seeks to limit the overproduction and consumption of the good or service in order to mitigate the effects of the externality. Taxation on production on the other hand simply increases the costs of production and therefore decreasing the amount produced, increasing the equilibrium price while raising tax revenue. A tax on carbon emissions is one approach that is being advocated to curb the amounts of greenhouse gasses being released into the atmosphere. Positive Externalities A positive externality is when a product or service creates an additional benefit to a third party that is not taken into account in the price of the product. When this benefit is not taken into account in by the consumer, it leads to an under production of the good or service. This type of externality acts upon the demand side of the market. Example: Vaccinations An example of this is vaccination for communicable diseases. When a person gets a vaccination they receive the benefit of a reduced or eliminated risk of getting sick. Additionally everyone around them receives the benefit of one less potential carrier of the disease. Therefore everyone else is slightly less likely to catch the disease for every additional person that receives the vaccine. At some point there is very little incentive for additional people to get the vaccine. Causes and Challenges. Positive externalities exist because it is not always possible to limit the benefits of a product to the consumer. Some consumers are able to receive the benefits of a product or service without paying. This is referred to as the free rider problem. This spill over benefits creates a disincentive for some people to purchase a good or service. There are additional benefits that are not taken into account in the price it lowers the amount of the product produced. Graphically, positive externalities cause the demand curve to be shifted to the left. This shift pushes the equilibrium price and quantity down. The amount of the decrease in price is the spillover benefit and the shift in the quantity supplied is the under allocation. The cumulative effect is an under allocation of goods at a lower equilibrium price. Positive externalities are generally entailed by the primary economic activity that is being produced. Ensuring that the patient who receives the vaccine cannot contract the disease is necessary for the vaccine to be effective. From the nature of disease transmission, someone who cannot contract the disease cannot pass it on. From the main effect of immunity, the secondary benefit of lowered transmission rates must follow. The secondary benefit cannot be separated sufficiently from the first. These kinds of benefits are normally seen as a good thing, they provide very good value. The problem comes with the reduced demand, which then reduces the quantity supplied below the optimal rate. Competition and Positive Externalities Competition fails to correct for positive externalities because of the disincentive created by the spillover benefit to consumption. There is no incentive on the consumer side to pay more for a benefit that they are already receiving. Competition amongst firms is ineffective because the price is already depressed, so there is no profit incentive or gap in the market for a new firm to enter and begin increasing production. Additionally there is no incentive for the third party receiving the free benefit to begin paying for it. Regulation and Solutions Like with negative externalities, the market distortions caused by positive externalities can be effectively remedied by regulation. The purpose of regulation with positive externalities is to increase the quantity produced to reach the socially optimal level of production. The government has two options for modifying the amount produced: Incentives and Mandates. If incentives are used they will encourage either the producer or consumer to purchase more of a product or service. The most common form of a government incentive is a subsidy. The subsidy can be given to the producer, which has the effect of decreasing the costs of production. This shifts the supply curve to the right, increasing the equilibrium quantity and decreasing the equilibrium price. In the case of a subsidy to the consumer, it shifts the demand curve to the right, increasing the equilibrium price and quantity. This increase in the price is offset by the subsidy to the consumer. If mandates are used the government can again act on either the supply side or the demand side. If the government chooses to act on the supply side, it generally takes the form of providing the good or service directly to consumers or through appropriate distribution channels such as hospitals or clinics. If the government chooses to act upon the demand side they mandate that people purchase a certain good or service. An example of this is mandating that children receive vaccinations before being allowed to attend public schools. This mandate forces the consumption of vaccinations to rise. Another example would be that of national defense. Everyone in the nation benefits from national defense, however not everyone want to participate in a war or conflict. In the event of a crisis the all volunteer army may not be sufficient to fulfill the nation’s needs. Therefore men are required to register for selective service, allowing a ready reserve of young men in the event they are needed. Rate Structures Pricing Elements Utilities enjoy the unique economic condition of being natural monopolies. Natural monopolies, as discussed earlier, are firms that due to the economies of scale, a single firm can provide goods or services at a lower price than a number of competitive firms serving the same area. Natural monopolies are fairly common amongst utilities. Water, electricity, telephone, and rail road services all share the characteristics which help natural monopolies form. Each requires significant infrastructure investment in order to transport the good or service to the customer and can achieve economies of scale fairly easily over a local area once capital has been invested. Each of the three examples requires significant capital investment in order to be established. Telephone companies require extensive physical as well as technological infrastructure. They must string hundreds of miles of wire or cable, switching and communications relays. Electricity providers require generation facilities such a coal fired power plants, or wind farms. Secondly they must have power lines, sub-stations, and finally meters. This infrastructure requires not only the costs of the materials but also securing right of way for the transmission lines. Water utilities are similar in their infrastructure requirements. They require pipes, water towers, pumping stations as well as treatment sites for sewage and waste water. In all three cases the capital costs present significant barriers to entry for any new firms that would attempt to enter the market. The result of these natural monopolies is, if left unregulated, they can charge monopoly prices for essential goods and services. This means that monopoly would maximize profits by restricting production to where the marginal cost function is equal to the marginal revenue function. Then charging whatever price the market would bear for that restricted amount of production. In order to avoid this, utilities are either taken over by the public or are strictly regulated. The monopolies are generally left in place rather than broken up because of the economies of scale that a single firm can provide under natural monopoly conditions. An alternative to this is the deregulated model where distribution is handled by a single firm while multiple firms compete for the input prices. I will focus on the natural monopoly case as it applies more broadly to public utilities. Pricing Objectives When the price controls are put in place the public utility or regulatory commission takes into account several factors. I will discuss these factors and then their application to water, power and telephone utilities. The foremost concern for pricing utilities is ensuring that the cost is lower than what would be charged under a pure monopoly. The firm must also be able to remain in business at the very least covering the costs of production. Growth projections and technological change should also be taken into account in a pricing system in order to ensure the future viability of the utility. The final consideration is for a reasonable return to be made by those providing the capital invested in the utility. Several pricing strategies have been advocated in order to achieve this and maintain a level of fairness. Each takes into account different needs of the firms and stakeholders. Marginal Cost Pricing The first and economically most efficient pricing strategy is to charge the marginal cost or average marginal cost for the service. This is the most efficient as it most closely mimics a truly competitive market where the equilibrium price will settle where marginal cost curve meets the demand curve. This model will lead to the theoretically most optimal pricing and production levels. There are significant fairness and planning problems with this however. Take the example of an electrical utility. If the utility only charges the marginal cost or average marginal cost they are paying for the fuel used in the production and the maintenance that would be required to transmit that power. The firm would likely be operating at a loss at this point. The average cost of production would be higher than the marginal cost or average marginal cost due to the significant capital requirements of the industry. There is the significant infrastructure investment as well as planning for the future that is not taken into account under a marginal cost pricing system. While marginal cost pricing may be the most efficient it is far from fair to the firm and also threatens to handicap the firm’s future viability. In the event that marginal cost pricing fails to meet the firm’s obligations it may be necessary to subsidize it in order to ensure its continued operation. Planning Pricing A second pricing strategy, that I will call planning pricing adds to marginal cost pricing. To marginal cost it adds a reasonable amount for planning, technology and infrastructure improvement. As public utilities operate it is in the best interest of the community for the utility to plan for expansion and growth as the community grows. Also there is a need to pay for the adoption of new technology as it is brought online. This can come directly in the price or be paid for by additional fees, like the adoption of digital meters is currently being paid for. In the example of an electric utility, marginal cost will cover the cost to produce and transmit the electricity. A small additional sum allows the electrical utility to run new power lines to areas of expected and current growth. Allowing for planning and technology change also allows in the long run for the economies of scale to become greater. As technology improves for more efficient storage, transmission and distribution there is less loss of electricity during these necessary processes. This allows for more efficient transmission of electricity during later years, and all things being equal, results in a lower per unit cost in the future. This approach is less economically efficient than a marginal cost pricing structure. It is more fair to both the public utility firm by allowing for future planning and investment to occur as well as an expanding community, by allowing new members to have access to the utilities that the existing community can benefit from. This pricing plan takes into account the current and future needs of the community that the utility serves. Reasonable Return The third and final pricing structure I will discuss, I will refer to as a reasonable return pricing structure. Under a reasonable return pricing structure the utility is allowed to make a certain amount of economic profit above and beyond the marginal cost of production of electricity. This can be used either in conjunction with a planning pricing model or in place of it. If used in conjunction the amount of economic profit allowed is likely to be less, but still gives the stakeholders in the utility firm an economic return on their capital investment. This return provides and ongoing incentive to maintain and increase production capacity as demand in the community grows. Also it allows for the capital necessary to update technology employed by the utility. If used in place of a planning price structure it allows the utility to make a reasonable profit, which would then incentivize the utility make future investments in infrastructure and efficacy in order to grow their customer base. Reasonable return pricing is the least likely to operate at the economically efficient price and quantity level, it is the most fair. It takes into account the current consumers, future consumers and firm. Each of the pricing structures addresses specific needs, if used in combination they can ensure the continued operation of public utilities while providing a reasonable return for the stake holders and lower costs to the consumer than under monopoly pricing conditions. While these concerns there is the additional element of changing rates with time that can help ensure adequate capacity and alleviate the need to raise prices uniformly. Time-Variant Rates Utilities and consumers can both benefit from variable rates in order to ensure that available utility capacity is used wisely. I will look at two time variant rate situations. The first is the use of peak-load pricing in electricity, the second is day time calling rates in telephone services. The main reason that rates should vary depending upon time is that demand fluctuates between high use times and low use times and the capacity of the infrastructure and transmission mechanisms to handle demand are limited. If time variant pricing is implemented effectively the goal is to smooth out demand across periods of time that would otherwise have differed significantly. The peak times of demand often create problems for the utilities due to the limitations inherent in the services being provided. Electricity The clearest example of time variant rates is in electricity. Electricity is a good candidate to examine time variant pricing for two reasons. First it is difficult to store. The electricity in the system as a whole is either being used, wasted or transferred to another area of higher demand. Second the infrastructure is limited in its capacity to provide electricity. The amount of electricity used varies over the course of the day. The lowest demands are made at night while the highest demands are made during the day while businesses are operating. The times of highest demand are called peak-load times. During peak-load times the transmission capacity and amount of electricity available can reach critical points. In the event that there is insufficient electricity or capacity to meet demand this can result in power outages to part or the entirety of a local electrical grid. By allowing the utility to vary the rate charged for electricity depending upon when it is used, the utility can incentivize customers shift demand from peak-load time to off-peak times. This shift of demand allows the electrical utility to protect its infrastructure as well as ensure that the total demand for electricity can be met regardless of when it occurs. The smart-grid is simply an extension and refinement of the idea of shifting demand from times of peak load times of lower demand. Once fully implemented it will be able to request that load for non-essential activities be reduced in order maintain the stability of the electrical grid. This model is both efficient and fair to all parties. Essentially, what this rate structure does is creates a sub market for the most demanded electricity. The more highly demanded electricity naturally ought to be priced accordingly. It also ensures better quality of service for the consumer by reducing power outages. This is also fairer to the utility provider. The utility provider is compensated for the additional stress and maintenance that peak loads Telephone Charging for variation in calling times allows telephone companies to shift demand from times of high demand to times of low demand. Like in the market for electricity, the telephone infrastructure has limited capacity and also experiences times of peak demand. While capacity is left idle that resource expires. Shifting demand from high to load demand ensures stable utilization rates. Most of the telephone capacity is used during the day when businesses are in operation. This has lead to discounted rates on nights and weekends when the call volume is lower. By allowing this incentive to call during non-peak times it allows the phone company to lower the number of disconnected calls, while efficiently segmenting the market. This segmentation is fair to both consumers as well as the provider due to the increased utilization that would be caused during peak usage if time variant pricing was not used. By allowing for rate variation it allows utilities to smooth out demand by segregating the market for high service time from low demand service times. Smoothing out demand allows for services to be more stable and limit the damage to the infrastructure transmitting the service. References Crew, Michael A. & Kleindorfer, Paul. R. (1979). Public Utility Economics. New York: St. Martin’s Press. Brue, Stanley L. & McConnell, Campbell R. (2002). Microeconomics: Principals, Problems and Policies. 15th ed. Boston: McGraw Hill. Read More