Question

As noted in the chapter, separating the production of electricity from its delivery has led to considerable deregulation of producers.

a. Briefly explain which of these two aspects of the sale of electricity remains susceptible to natural monopoly problems.

b. Suppose that the potential natural monopoly problem you identified in part (a) actually arises. Why is marginal cost pricing not a feasible solution? What makes average cost pricing a feasible solution?

c. Discuss two approaches that a regulator could use to try to implement an average-cost-pricing solution to the problem identified in part (a).

Short answer

(a) The production process remains more vulnerable than the distribution process due to its overpricing issue.

(b) Marginal cost pricing is inefficient since the price is always lower than the average.

(c) Rate of return and Service cost regulation.

Step-by-step solution

Given Information

Given data:

The separation of electricity generation and delivery has resulted in significant deregulation of producers, and two components of power sales remain vulnerable to natural monopoly difficulties.

Aspects of the sale of electricity remains susceptible to natural monopoly problems(part a)

Deregulation of gas and power generation is becoming increasingly popular.

(a) The natural monopoly issue is concerned with inefficient pricing and underproduction. The production process remains more vulnerable than the distribution process due to its overpricing issue.

Feasible solution(part b)

(b) Marginal cost pricing is inefficient since the price is always lower than the average. If the company continues to use marginal costing, it will lose money and eventually shut down. If the price is fixed at the average cost, enterprises will be able to cover their costs and produce at berak, resulting in no profit or loss.

Two approaches that a regulator could use to try to implement an average-cost-pricing(part c) 

(c) There are two aspects to deregulating natural monopolies:

- Rate of return. The rate of return pricing principle asserts that prices should be competitive without generating economic profits.

- Service cost regulation: According to this, the price should only cover the average cost in order to keep costs reasonable.

This theory is applied in natural monopolies, when prices are overcharged because average revenue is equated with price instead of marginal cost and revenue.