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 QM MWHs

4. $ Case 2: Marginal Cost Pricing D = AR  C1 LAC   PC LMC MR 0 QC MWHs

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 revenues—does 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

8. In summary, option 2 is superior on social welfare grounds—but 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 “compromise”and is best in terms of reconciling twoobjectives—i.e. maximization of the total surplusand the necessity to provide regulated firm a fair return