An Empirical Analysis of Ramsey Pricing in Japanese Electric Utilities

1. An Empirical Analysis of Ramsey Pricing in Japanese Electric Utilities By: Isamu Matsukawa, Seishi Madono and Takako Nakashima Presented by: Sarah Noll

2. Introduction • Very few studies have be conducted on the Japanese electric utilities. This study investigates whether the regulated prices satisfy the Ramsey pricing conditions. • Japanese electric utilities are local monopolies and are subject to regulation. • The price of electricity is determined by the Fully Distributed Cost (FDC) method. • Common costs are allocated to service based on their relative shares of output, peak demand, revenue, attributable cost, etc. • Therefore, the unit price for industrial customers served at higher voltages is less than the unit price for residential customers.

3. Introduction • Japanese electricity utilities provide services in competitive and noncompetitive markets. • Self-generation and cogeneration have grown due to lower prices of oil, coal, and gas. • Increased competition in the supply and distribution of electricity • A higher portion of common costs is passed onto remaining customers • Creates a cycle of customers switching to alternative generation and higher prices for those that are left with the utility. • The socially inefficient outcome in which losses for utilities and remaining customers exceed the benefits of customers using self-generation and cogeneration may result. • Solution: Ramsey Pricing.

4. Introduction • Constructed an econometric model of electricity production and demand to examine the effect of regulation on electricity prices in Japan. • Sample of 9 utilities from 1980-1988. • Tests whether observed patterns of electricity prices satisfy the Ramsey pricing conditions. • If the pricing patterns are not different from Ramsey pricing, the increase in self-generation and cogeneration will not necessarily bring about a socially inefficient outcome.

5. The Model • Ramsey Pricing • Two assumptions: • (1) the multiproduct monopoly has scale economies and alternative generation sources do not and • (2) outputs of the multiproduct monopoly are imperfectly substitutable for those of alternative generation sources, the second-best prices must satisfy the condition that, for all products provided by the natural monopolist,

6. The Model • The Ramsey Rule: • Low elasticity markets get high markups • High elasticity markets get low markups • No regulation of alternative generation sources is required • An advantage is that is less costly because only the monopolist is regulated

7. Cost Function for the Electric Utilities • Marginal cost estimates for each output are obtained from estimation of a three-factor translog multiproduct cost function • Only using industrial and residential customers • Assume that the two customer groups have identical marginal costs and aggregate these two classes when estimating the utility’s cost function

8. Fuel Costs Function for Industrial Customers The translog functional form is used to represent the energy cost function for industrial customers as: Fuel Cost Share Equation:

9. Fuel Costs Function for Industrial Customers Price Elasticities for Purchased Power from the utility are given by:

10. Fuel Expenditure Function for Residential Customers For the almost ideal demand system, the total fuel expenditure function of residential customers is given by:

11. Data and Estimation Methods • The cost share equation for gas is deleted to avoid singularity in the fuel cost share equation for industrial customers. • For the residential fuel expenditure function, restrictions on parameters are imposed to satisfy homogeneity of degree zero in prices and total fuel expenditure and Slutsky symmetry: • All equations of the fuel demand system must have joint normal additive disturbances • The iterative Zellner efficient estimation procedure is used to obtain maximum likelihood estimates • The expenditure equation for kerosene is removed from the system to avoid singularity

12. Estimation Results • Region-Specific effects on cost and demand structures are examined by including region-specific constants in the cost function of the utility and fuel cost function of customers. • Results show that region-specific effects are not significant for all cross-section units of residential customers. • For industrial customers the fuel cost function had significant coefficients for most regional dummies.

13. Estimation Results • The assumption that parameters in electricity cost and demand functions are identical throughout the entire estimation period may not be appropriate because of the effects of shocks associated with technological and or institutional factors on the economic behavior of the utility and customers. • The Chow test was used to test the stability of estimated coefficients, • Two periods 1980-1984 and 1985-1988 • Do not reject the hypothesis that the relationship is stable for both electricity cost and demand functions

14. Estimation Results All three own-price elasticities are negative Fuel has the largest own-price elasticity , which can possibly reflect the fact that fuel input is relatively easy to adjust when input prices change. Positive values of cross-price elasticity indicate substitutability.

15. Estimation Results All four have negative own-price elasticities On average coal is the highest Positive values of cross-price elasticity indicate substitution possibilities between the fuels

16. Estimation Results Electricity is a substitute for gas and a complement for kerosine. Gas has the highest own-price elasticity.

17. Estimation Results Second-best pricing by the electric utility was tested using condition (1). T-stat implies that the null hypothesis of equality in Ramsey numbers is rejected at the 0.01 significance level.

18. Statistical Test for Ramsey Pricing The regulated prices of electricity in Japan for the period 1980-1988 did not satisfy the Ramsey pricing rule. Social welfare can be raised by choosing alternative sets of electricity prices that satisfy the Ramsey pricing conditions. The estimates of Ramsey numbers on average for industrial customers are 0.210 and 0.062 for residential customers. Positive numbers indicate both customers faced electricity prices above marginal costs.

19. Numerical Example of Ramsey Prices Estimates of Ramsey optimal prices for residential and industrial customers. 35% increase in Residential prices would be required

20. Conclusion • Price effects on residential and industrial electricity demand are not negligible and electricity turns out to be a substitute for other fuels. • Markups of price over marginal cost are positive for both residential and industrial customers, with residential markup small than that for industrial customers. • The test result rejects the hypothesis that the rate regulation satisfies the Ramsey optimal criteria, and the movement from actual prices to Ramsey prices may require: • A large increase in residential prices • A slight decrease in industrial prices