Social Pricing and Rural Issues

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[Response by Sophie Trémolet and Diane Binder, June 2009]

In a perfectly competitive environment¹, both economic and social objectives are achieved when tariffs are set at the marginal cost of provision. Indeed, social objectives are to maximize the welfare² of consumers, i.e. to maximize the difference between the value they place on the service and the cost of service provision. Welfare is therefore maximized when service is provided at marginal cost. Economic objectives are met when operators can maximize their profits: in a perfectly competitive environment, operators will charge prices equal to marginal costs. In such a case, social and economic objectives are aligned. In addition, tariffs set at the marginal cost of provision lead to a more efficient use of the service.

However, operators providing utility services have certain cost characteristics that make them a natural monopoly. In a monopoly situation, profit-maximizing prices charged by operators need to exceed their marginal cost of provision, in order to recover the amount of capital sunk in the first place so that the operators can be commercially viable³.

Since allocatively efficient pricing is not possible, Ramsey Pricing offers a second-best solution, where individual prices would be raised above marginal costs according to the service’s price elasticity of demand. That means that operators would have certain price flexibility within service baskets⁴ defined by the regulator, and that certain types of customers (those whose demand is said to be more inelastic) would pay a higher mark-up above marginal cost than another type of customers.

Whereas this price structure would be more efficient economically in an aggregate sense, Ramsey Pricing raises issues in terms of fairness. Customer groups with relatively inelastic demands (which often means without substitutes) will pay a higher price, which is against the principles set by a regulator. Furthermore, some customers with relatively inelastic demands may acquire a strong incentive to seek alternatives if charged higher markups, thus undermining the approach. Politically speaking, customers with relatively inelastic demands may also be viewed as those for whom the service is more necessary or vital; charging them higher markups can be challenged as unfair or socially undesirable⁵.

Targeted subsidies with lifeline rates and connection subsidies may be a better way of reconciling efficiency and fairness, with minimal losses in terms of efficiency⁶. Connection subsidies would give an incentive to operators to expand services at cost in areas where capacity to pay of customers would usually not meet the capital and operation cost requirements. Targeted subsidies to low-income consumers can combine economic and social objectives⁷.

Related Questions

• What do regulators need to do differently to tackle the needs of poor consumers?
  • What should regulators do to meet social objectives set by policy-makers?
  • Should social objectives be met through funds obtained at the national level and allocated to meet the objectives in each sector and region?
  • What are the advantages and disadvantages of creating dedicated agencies or « funds » to support the development of infrastructure services in rural areas? How should the regulator relate to such funds?
  • Are successful programs for peri-urban areas appropriate for rural areas?
  • Do higher income customers benefit more from subsidies than do poorer customers?
  • How can a regulator promote investment while keeping service prices affordable?
  • What procedures should the regulator adopt in order to balance economic and social objectives (like efficiency vs. fairness)?
  • What are the strength and limitations of lifeline rates?
  • When and why would the regulator choose not to regulate the price structure, leaving the task to the operating company?
  • In an industry where an aging network and generation capacity constraints lead to poor service delivery, to what extent should consumers contribute towards capital expansion?
  • Since rates in the water sector seldom reflect full cost recovery, how can you convince citizens to accept higher prices (given their willingness to pay)?
  • To what extent does service quality need to be the same for high and low cost areas?

Footnotes

1. See “competitive conditions” in the glossary. Back to Content
2. See “economic welfare” and “social welfare” in the glossary. Back to Content
3. See Chapter 2 Section B. Back to Content
4. Sub-markets subject to similar degree of competition (Ed.). Back to Content
5. See Chapter 5 Section B-2. Back to Content
6. See question 9 for discussions on the strength and limitations of lifeline rates. Back to Content
7. See question 2 about meeting social objectives and question 6 about the importance of targeting subsidies. Back to Content