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A Decentralized Method for Utility Regulation Author(s): Martin Loeb and Wesley A. Magat Reviewed work(s): Source: Journal of Law and Economics, Vol. 22, No. 2 (Oct., 1979), pp. 399-404 Published by: The University of Chicago Press for The Booth School of Business of the University of Chicago and The University of Chicago Law School Stable URL: http://www.jstor.org/stable/725125 . Accessed: 01/12/2012 14:53
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A DECENTRALIZED METHOD FOR UTILITY REGULATION

MARTIN LOEB and North Carolina State University WESLEY A. MAGAT Duke University

I.

INTRODUCTION

UNTIL

1968 most economists accepted the inevitability of regulating natural monopolies; however, in that year Harold Demsetz published an important article in this journal suggesting that conventional analysis erred in its failure to consider the franchise bidding stage.' He argued that competition at the franchise award stage would be sufficient to reduce the price of service below the monopoly level, even though the increasing returns to scale dictated that only one firm actually supply the service. This novel approach was proposed as an alternative to rate-of-return regulation, which economists have long recognized to represent only an imperfect solution to the problem of natural monopoly.2 Demsetz3 replied to some criticism from Lester G. Telser4 but did not address the question of how the franchise agreement was to be adapted to changing supply and demand conditions. Oliver E. Williamson recently explored the problems associated with awarding and monitoring franchise agreements, concluding that in many cases the franchise arrangement may not be superior to the regulatory solution.s The problem of alleviating the social losses associated with natural monopoly does not reduce to the question of control by regulation or control by franchise agreement, for both systems of control are imperfect and a franchise agreement may require a regulatory body to oversee its administration. 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 with Respect to CATV, 7 Bell J. Econ. 73 (1976). Victor Goldberg has also reached this conclusion in recent studies. See Victor P. Goldberg, Competitive Bidding and the Production of PreContract 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 monopoly.6 This paper suggests a new institutional arrangement that mixes regulation and franchising and which eliminates many of the problems of both systems. It is no panacea, for some problems still remain, but our system does capture many of the desirable properties of both the regulation and franchise arrangements. We believe that the only way to escape the disagreeable choice between regulation and franchise control is to design new social institutions. Our paper represents a step in that process.
I.

DECENTRALIZED SYSTEM OF REGULATION

We propose a system in which the utility chooses its own price and the regulatory agency subsidizes the utility on a per unit basis equal to the consumer surplus at the selected price. Assume that the regulatory agency and the utility know the demand curve for the utility's output. Also, assume that the utility knows its own marginal cost curve; the regulatory agency need not have any information about this curve. The system is easily illustrated using Figure I in which the demand curve is labeled d and the marginal cost curve is labeled mc. Suppose the utility selects the (competitive) price P. The utility will collect area OQAP from sales to its customers and area PAB as a subsidy from the regulatory agency. As the utility incurs (variable) costs equal to the area OQAC in producing Q units, its (variable) profits will be area CAB. If the utility chooses any other price, such as P, it will sell Q units, collect area OQEP from customers and area FEB from the regulatory agency, and incur (variable) costs equal to area OODC. Hence by charging a price P different from P, its profits are reduced by the area DAE.7 This illustration demonstrates that under the proposed system a utility is motivated to choose the (competitive) price P where the demand curve cuts the marginal cost curve. With this procedure consumers are paying a price which, at the margin, equals the cost of providing the service, so the efficient quantity 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 Harold Demsetz, Information and Efficiency: Another Viewpoint, 12 J. Law & Econ. 1 (1969). 7 If fixed costs are greater than 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 demand curve and d(Q) be the inverse demand curve. Define D(Q) d(q)dq to be the area of cost function. The under the demand curve from 0 to Q and let represent the utility's C(') regulatory agency subsidizes the utility by
S(P) = D[Q(P)] - P-Q(P) - A,

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METHOD FOR UTILITY REGULATION

401

Price
B

mc ,

0I

d
0
FIGURE I

'

Quantity

cost curve was drawn to be decreasing, this was inconsequential to the above argument.9 Besides solving the allocative efficiency problem, the system also encourages efficient operation. Any reductions in cost are immediately rewarded. For example, in Figure I if the elimination of waste could reduce marginal cost to mc', then the added profits CGHA would accrue to the utility. The firm continues to reap the benefits of the cost reduction indefinitely. This
where A is any lump-sum charge calculated independently of the price P selected by the utility. The utility selects a price to Maximize + S(P) - C[Q(P)]. P.Q(P) On combining the above two equations, the first-order conditions require that

= C'[Q(P)]. d[Q(P)]
9 Although allowing a monopolistic firm to practice perfect price discrimination will produce the 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 solution than does a regulatory method based on price discrimination. It does not need the individual demand information which is necessary to segment the market for price discrimination and it need not segment the market in order to extract the full consumer surplus from all users.

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contrasts with rate-of-return regulation, under which the rewards to cost reduction are rescinded at the next rate review. With the present system, rate decisions are centralized in the Utilities commission, so it must rely at least partially upon the utilities themselves for cost information. This creates a strong incentive for the utilities to overstate their costs of capital, operating costs, depreciation rates, and the like. The proposed system eliminates the regulatory agency's need for cost data from the utility because price decisions are decentralized. It eliminates any incentive for the utility to overstate its true costs and avoids the expenses of collecting and verifying cost data. This price-setting decentralization leads to perhaps the system's strongest asset: it requires no action by the regulatory agency if underlying cost conditions change. Under both rate-of-return regulation and a franchising arrangement, a regulatory or administrative agency would normally be required to act if inflationary pressures squeezed profits, local supply conditions changed, or technological improvements lowered costs. Under our proposed system a utility would be provided with a strong incentive to adapt quickly to these changing cost conditions and bring price back into equality with marginal cost, without any prodding from a regulatory agency.10 No regulatory action is required, so regulatory lag is avoided."
II. FRANCHISE SALES AND A LUMP-SUM TAX

Some may object to the proposed regulatory scheme since it requires a substantial subsidy to the utility. The new method of regulation defined so far involves a subsidy equal to the area between the demand curve and the price charged (PAB in Figure I). Subsidies have been traditionally opposed on the grounds that they require taxation of other sectors of the economy, which may cause additional allocative inefficiencies and represent a highly visible form of income redistribution (from the general public to utility customers) that may be considered objectionable to some. The scheme presented here can be combined with the sale of a franchise to reduce or even eliminate the net subsidy provided to regulated firms, while retaining the attractive features of price decentralization and the decen10 We should point out that our scheme does not protect the consumer against rapid price rises, which may or may not be cost-justified. One desirable characteristic of traditional forms of regulation may be that consumers prefer gradual changes in price, even when large cost increases dictate rapidly rising utility rates. Certainly the problem of rapidly rising prices which are based on irrational action by the utility's management, rather than on cost increases, is a serious consideration. I The system also provides a strong incentive for innovation. If the reduction in marginal cost to mc' in Figure I was produced by a technological advance, then the reward CGHA would accrue to the utility. That added profit would be earned indefinitely, for regulatory review would not terminate the benefits of the cost reduction to the firm.

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METHOD FOR UTILITY REGULATION

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tralization of cost information. Potential utilities would bid for the monopoly knowing it would be regulated (that is, subsidized) as described earlier. Under such circumstances we could expect bids to capitalize part of the subsidy, area CAB in Figure I (less fixed costs), so that the utility earns only normal profits. Notice that if marginal cost were constant and still intersected the demand curve at point A in Figure I, we would expect the winning bidder to fully capitalize the entire subsidy, bidding area PAB (less fixed costs), and if marginal cost were increasing then the winning bid could even exceed the subsidy.12 Rather than (or in addition to) selling a franchise, the regulatory agency may impose a lump-sum tax on the utility in order to recover part of the subsidy and to reduce the amount of information needed about the demand function. One such tax may be illustrated with the use of Figure II. The

Price
B

C Po

I I
I
FIGURE II

Quantity

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

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PoGB. With such a tax the utility would still have an incentive to select the price I', but now its variable profits would be area HGA less area PoHC.13

This tax also demonstrates that the regulatory agency does not need to know the demand curve over all prices, but only in the neighborhood of P. With the illustrated lump-sum tax, the regulator is acting as if the demand curve is piecewise linear through the points H, G, and A. 14

13 The regulatory agency would need to choose Po sufficiently high so that the utility would suffer no losses. It is likely that by observing other utilities and government-owned firms (such as 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-right sale in conjunction with the proposed system, see Martin Loeb & Wesley A. Magat, supra note 12, at 14-17. In particular, this reference further discusses the problems which may arise due to the need to estimate the utilities' demand curves.

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