By: PAUL M. HAYASHI MELANIE SEVIER JOHN M. TRAPANI Presented By: SIFAT SHARMEEN

1. PRICING Efficiency Under Rate of return regulationSome Empirical Evidence for the Electric Utility Industry By: PAUL M. HAYASHI MELANIE SEVIER JOHN M. TRAPANI Presented By: SIFAT SHARMEEN

2. Objective The purpose of this paper is to develop a method for testing the rate-of-return formulation of the quasi-optimal pricing rule and apply the methodology to a sample of electric utility firms.

3. Why this paper is interesting? • The first effort to model the cost structure of regulated firms to evaluate impact of rate-of-return regulation on optimal pricing in the electric utility industry. • Both the cost and demand structures for the sample of firms are estimated so that the estimates of marginal cost and demand elasticities are unique to the firms under study. • Previous studies have relied on outside estimates of either cost or price elasticities of demand. • Represents the first attempt to explicitly solve for the quasi-optimal price structure implied by the cost and elasticity estimates and provide an assessment of the distribution of benefits of rate-of-return regulation across customer classes.

4. quasi-optimal pricing • Reflects the fact that an allowable return on capital set above the market return will increase producer welfare at the expense of consumer welfare. • Empirical studies of pricing efficiency of the multiple outputs of electric utility firms in the U.S. have relied on quasi-optimal pricing rules developed for the fixed profit constraint case.

5. Rate of return regulation and welfare maximization • To determine the profit max prices the paper is based on result from a two-stage process: 1.Regulatory body determines the "fair rate-of-return to capital” s • > s > r Where r→ market cost of capital → rate achievable at the monopoly profit maximizing solution 2.Determine the quasi optimal prices

6. Maximizing consumer plus producer surplus subject to the constraint that the firm will earn the maximum allowable profit where R =total revenue S =consumer surplus =is regulated cost C*= is total production cost K*=is the firm's capital choice under rate-of-return regulation Regulated Cost : C* is the cost incurred by the firm maximizing profit subject to a rate-of-return constraint.

7. Differentiating (1) with respect to qi yields pi=the price of the ithoutput = the absolute value of the price elasticity of demand for the ithoutput regulated marginal cost Setting equation (3) equal to zero yields Condition (4) is the quasi-optimal pricing rule for welfare-maximization in the presence of a rate-of-return regulatory constraint.

8. relation between regulated marginal cost and marginal cost to the producing unit From equation (2) substitute (5) into (3) we arrive at the following variant of the quasi-optimal pricing rule. percentage markup of price over marginal cost for each output produced =usual fixed-profit distortion term involving the price elasticity of demand + the excess capital valuation under rate-of-return regulation.

9. If s=r, then = • If s>r, presence of the rate-of-return constraint will require a greater difference between price and marginal cost at the optimal solution. If capital is a normal input then regulated marginal cost will exceed MC* and the fixed-profit formulation of the pricing rules would understate the desired markup of price over marginal cost.

10. Empirical Model Specification • Multiproduct cost function for the typical privately-owned electric utility firm regulated on the basis of a fair rate-of-return to capital • In general, if s > r then C*> C f is an index of fuel cost qi are various outputs by class of customer

11. Shephard's lemma is modified to identify the minimum cost input level Lagrangian multiplier of the rate-of-return constraint K, L, and F = cost minimizing input levels

12. Regulated Cost Function • The regulated cost function is given by Where K* designates the constrained profit maximizing level of capital input. • Express the regulated function as when regulation is effective, C* for two reasons. • the input distortions due to a binding rate-of-return constraint and • the valuation of capital at s, the allowable rate-of-return to capital.

13. translog form of the regulated cost function

14. Using Shephard's lemma and the properties of the regulated cost function, the factor cost share equations for labor and fuel are derived as follows The regulated marginal cost curve can be written as

15. Demand Functions • For residential customer:

16. Commercial & Industrial

17. Cost equation result

18. The regulated and measured marginal cost equations implied by these results are given in Table II

19. Demand equation results • presents the demand equation parameter estimates for the residential customers. • price elasticity of demand is -1.08156 in 1965 and • -1.10891 in 1970.

20. Tests for pricing efficiency • Actual price of electricity VS Quasi-optimal pricing

21. The first column shows markup of price over regulated marginal cost for each class of customer. • Percentage markup is similar for residential ad commercial users but lower for industrial users. • Consistent with other studies. • The last column reports the markup for each customer class weighted by the price elasticity of demand for that class. • If the value of the weighted markup is the same for each customer class, then the price structure is quasi-optimal but it is not same here in this sample. • The finding here is that welfare improvements might be possible under an alternative price structure by class of customer.

22. Conclusion • Results indicate that the price structure of electricity by class of customer for the firms in this sample is not quasi-optimal and that welfare improvements might be possible under alternative prices for the customer classes. • commercial user rates have been too high relative to residential and, to a lesser extent, industrial rates. • Adjustment to the optimal solution requires a lowering of commercial rates and increases in residential and industrial rates. • This outcome is fairly consistent with the general theory of regulation.

23. Questions?

24. Thank YOU