The Regulatory Dilemma

1
The 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.
Professor, What do you mean by the term
regulatory dilemma
2
The horns of the dilemma
The socially efficient regulatory regime does
not provide a fair return to the regulated firm
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.
3

Case 1 Unregulated Monopoly
?
PM
?
D AR
CM
?
LAC
?
LMC
MR
0
QC
MWHs
QM
4

Case 2 Marginal Cost Pricing
D AR
?
C1
LAC
?
?
PC
LMC
MR
0
MWHs
QC
5
Recall the necessary conditionfor socially
efficient resourceallocation P MC

• Hence
• Option 2 is optimalon social efficiencycriteria.
  
• Why not select option2 and subsidize the
  regulated firm by amountC1??PC?

Subsidies give rise to problems of
distributional equity. For example, supposethat
gas companies were subsidies from general tax
revenuesdoes this not amount to an income
transfer to gas customers from tax payers that
areall electric?
6

Option 3 Average Cost Pricing
?
PA
?
LAC
?
LMC
MR
0
QA
MWHs
7
Comparing the results
Option Price Quantity Dead Weight Loss given by area EconProfit given by area
1 PM QM ??? PM??CM
2 PC QC 0 (C1??PC)
3 PA QA ??? 0
8
In summary, option 2 is superior on social
welfare groundsbut fails toproduce 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
compromiseand is best in terms of reconciling
twoobjectivesi.e. maximization of the total
surplusand the necessity to provide regulated
firm a fair return