Loeb and Magat - (Tarificacion Monopolios) a Decentralized Method for Utility Regulation

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The University of Chicago

The Booth School of Business of the University of Chicago

The University of Chicago Law School

A Decentralized Method for Utility RegulationAuthor(s): Martin Loeb and Wesley A. MagatReviewed work(s):Source: Journal of Law and Economics, Vol. 22, No. 2 (Oct., 1979), pp. 399-404

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A DECENTRALIZED METHOD FORUTILITY REGULATIONMARTIN LOEB and WESLEY A. MAGAT

North Carolina State University Duke University

I. INTRODUCTIONUNTIL 1968 most economists accepted the inevitability of regulatingnatural monopolies; however, in that year Harold Demsetz published animportant article in this journal suggesting that conventional analysis erredin its failure to consider the franchise bidding stage.' He argued that compe-tition at the franchise award stage would be sufficient to reduce the price ofservice below the monopoly level, even though the increasing returns to scaledictated that only one firm actually supply the service. This novel approachwas proposed as an alternative to rate-of-return regulation, which econo-mists have long recognized to represent only an imperfect solution to theproblem of natural monopoly.2 Demsetz3 replied to some criticism fromLester G. Telser4 but did not address the question of how the franchiseagreement was to be adapted to changing supply and demand conditions.Oliver E. Williamson recently explored the problems associated with award-ing and monitoring franchise agreements, concluding that in many cases thefranchise arrangement may not be superior to the regulatory solution.sThe problem of alleviating the social losses associated with naturalmonopoly does not reduce to the question of control by regulation or controlby franchise agreement, for both systems of control are imperfect and afranchise agreement may require a regulatory body to oversee its administra-tion. The fundamental question is one of comparative institutional choice;

1 Harold Demsetz, Why Regulate Utilities, 11 J. Law & Econ. 55-56 (1968).2 As an example, see Richard A. Posner, Natural Monopoly and Its Regulation, 2 Stan. L.Rev. 548-643 (1969).3 Harold Demsetz, On the Regulation of Industry: A Reply, 79 J. Pol. Econ. 356 (1971).4 Lester G. Telser, On the Regulation of Industry: A Note, 77 J. Pol. Econ. 937 (1969).s Oliver E. Williamson, Franchise Bidding for Natural Monopolies: In General and withRespect to CATV, 7 Bell J. Econ. 73 (1976). Victor Goldberghas also reached this conclusion inrecent studies. See Victor P. Goldberg, Competitive Bidding and the Production of Pre-Contract Information, 8 Bell J. Econ. 250 (1977). Id., Regulation and Administered Contracts,7 Bell J. Econ. 426 (1976).

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What institutional arrangement will minimize the costs of natural mo-nopoly.6This paper suggests a new institutional arrangementthat mixes regulationand franchising and which eliminates many of the problems of both systems.It is no panacea, for some problems still remain, but our system does capturemany of the desirable properties of both the regulation and franchise ar-rangements. We believe that the only way to escape the disagreeable choicebetween regulation and franchise control is to design new social institutions.Our paper represents a step in that process.

I. A DECENTRALIZED SYSTEM OF REGULATIONWe propose a system in which the utility chooses its own price and theregulatory agency subsidizes the utility on a per unit basis equal to theconsumer surplus at the selected price. Assume that the regulatory agencyand the utility know the demand curve for the utility's output. Also, assumethat the utility knows its own marginal cost curve; the regulatory agencyneed not have any information about this curve.The system is easily illustrated using Figure I in which the demand curveis labeled d and the marginal cost curve is labeled mc. Suppose the utilityselects the (competitive) price P. The utility will collect area OQAP from

sales to its customers and areaPAB as a subsidy from the regulatory agency.As the utility incurs (variable) costs equal to the areaOQACin producingQunits, its (variable) profits will be area CAB. If the utility chooses any otherprice, such as P, it will sell Q units, collect area OQEP from customers andarea FEB from the regulatory agency, and incur (variable) costs equal toarea OODC. Hence by charging a price P different from P, its profits arereduced by the area DAE.7This illustration demonstrates that under the proposed system a utility ismotivated to choose the (competitive) price P where the demand curve cutsthe marginal cost curve. With this procedure consumers are paying a pricewhich, at the margin, equals the cost of providing the service, so the efficientquantity of the service is being provided.8 Notice that although the marginal

6 For an excellent discussion of the problem of comparative institutional choice, see HaroldDemsetz, Information and Efficiency: Another Viewpoint, 12 J. Law & Econ. 1 (1969).7 If fixed costs are greaterthan CAB and recoverable, the utility would choose not to produce.Such a decision, of course, would be socially optimal.The procedure may also be represented algebraically. Let Q = Q (P) be the utility's de-mand curve and d(Q) be the inverse demand curve. Define D(Q) - of d(q)dqto be the areaunder the demand curve from 0 to Q and let C(') represent the utility's cost function. Theregulatory agency subsidizes the utility by

S(P) = D[Q(P)] - P-Q(P) - A,



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METHOD FOR UTILITY REGULATION 401

PriceB

IC I

,mc

0Id

0 0 ' QuantityFIGURE I

cost curve was drawn to be decreasing, this was inconsequential to the aboveargument.9Besides solving the allocative efficiency problem, the system also encour-ages efficient operation. Any reductions in cost are immediately rewarded.For example, in Figure I if the elimination of waste could reduce marginalcost to mc', then the added profits CGHA would accrue to the utility. Thefirm continues to reap the benefits of the cost reduction indefinitely. Thiswhere A is any lump-sum charge calculated independently of the priceP selected by the utility.The utility selects a price to

Maximize P.Q(P) + S(P) - C[Q(P)].On combining the above two equations, the first-order conditions require thatd[Q(P)] C'[Q(P)].

9 Although allowing a monopolistic firm to practice perfect price discrimination will producethe same result, with the proposed system the monopolist charges a single price to all users.Thus our system provides what is considered by most people to be a more equitable solutionthan does a regulatory method based on price discrimination. It does not need the individualdemand information which is necessary to segment the market for price discrimination and itneed not segment the market in order to extract the full consumer surplus from all users.



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402 THE JOURNAL OF LAW AND ECONOMICScontrasts with rate-of-return regulation, under which the rewards to costreduction are rescinded at the next rate review.

With the present system, rate decisions are centralized in the Utilitiescommission, so it must rely at least partially upon the utilities themselves forcost information. This creates a strong incentive for the utilities to overstatetheir costs of capital, operating costs, depreciation rates, and the like. Theproposed system eliminates the regulatory agency's need for cost data fromthe utility because price decisions are decentralized. It eliminates any incen-tive for the utility to overstate its true costs and avoids the expenses ofcollecting and verifying cost data.This price-setting decentralization leads to perhaps the system's strongestasset: it requires no action by the regulatory agency if underlyingcost condi-tions change. Under both rate-of-return regulation and a franchising ar-rangement, a regulatory or administrative agency would normally be re-quired to act if inflationary pressures squeezed profits, local supply condi-tions changed, or technological improvements lowered costs. Under ourproposed system a utility would be provided with a strong incentive to adaptquickly to these changing cost conditions and bring price back into equalitywith marginal cost, without any prodding from a regulatory agency.10 Noregulatory action is required, so regulatory lag is avoided."

II. FRANCHISE SALES AND A LUMP-SUM TAXSome may object to the proposed regulatory scheme since it requires asubstantial subsidy to the utility. The new method of regulation defined sofar involves a subsidy equal to the area between the demand curve and theprice charged (PAB in Figure I). Subsidies have been traditionally opposedon the grounds that they require taxation of other sectors of the economy,which may cause additional allocative inefficiencies and represent a highlyvisible form of income redistribution (from the general public to utility cus-

tomers) that may be considered objectionable to some.The scheme presented here can be combined with the sale of a franchise toreduce or even eliminate the net subsidy provided to regulated firms, whileretaining the attractive features of price decentralization and the decen-10 We should point out that our scheme does not protect the consumer against rapid pricerises, which may or may not be cost-justified. One desirable characteristicof traditional formsof regulation may be that consumers prefer gradual changes in price, even when large costincreases dictate rapidly rising utility rates. Certainly the problem of rapidly rising prices whichare based on irrational action by the utility's management, rather than on cost increases, is aserious consideration.I The system also provides a strong incentive for innovation. If the reduction in marginalcost to mc' in Figure I was produced by a technological advance, then the reward CGHAwouldaccrue to the utility. That added profit would be earned indefinitely, for regulatory reviewwould not terminate the benefits of the cost reduction to the firm.



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METHOD FOR UTILITY REGULATION 403tralization of cost information. Potential utilities would bid for the monopolyknowing it would be regulated (that is, subsidized) as described earlier.Under such circumstances we could expect bids to capitalize part of thesubsidy, area CAB in Figure I (less fixed costs), so that the utility earns onlynormal profits. Notice that if marginal cost were constant and still inter-sected the demand curve at point A in Figure I, we would expect the winningbidder to fully capitalize the entire subsidy, bidding area PAB (less fixedcosts), and if marginal cost were increasing then the winning bid could evenexceed the subsidy.12Rather than (or in addition to) selling a franchise, the regulatory agencymay impose a lump-sum tax on the utility in order to recover part of thesubsidy and to reduce the amount of information needed about the demandfunction. One such tax may be illustrated with the use of Figure II. ThePriceB

CPo H GP III d0 QuantityFIGUREII

regulatory agency selects a pricePo prior to the utility's choice of the (actual)price P. The utility is then charged the lump-sum tax represented by area12 See Martin Loeb & Wesley A. Magat, Decentralization, Utility Regulation, and Franchis-ing: A New Approach 12-13 (1977) (Working Paper No. 214, Graduate School of BusinessAdmin., Duke Univ.), for a discussion of why we believe that the proposed method of regula-tion, with the initial sale of a franchise right, representsan improvement upon both the existingform of rate-of-return regulation practiced in this country and the system of franchising pro-posed by Harold Demsetz, supra note 1.



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PoGB. With such a tax the utility would still have an incentive to select theprice I', but now its variable profits would be area HGA less area PoHC.13This tax also demonstrates that the regulatory agency does not need to knowthe demand curve over all prices, but only in the neighborhood of P. Withthe illustrated lump-sum tax, the regulator is acting as if the demand curve ispiecewise linear through the points H, G, and A. 14

13 The regulatory agency would need to choose Po sufficiently high so that the utility wouldsuffer no losses. It is likely that by observing other utilities and government-owned firms (suchas the TVA), the agency would possess sufficient information to select such a price.14 For further discussion of the use of both the lump-sum subsidy and the franchise-rightsalein conjunction with the proposedsystem, see Martin Loeb &Wesley A. Magat, supra note 12, at14-17. In particular, this reference further discusses the problems which may arise due to theneed to estimate the utilities' demand curves.

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Loeb and Magat - (Tarificacion Monopolios) a Decentralized Method for Utility Regulation