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Is it the case that firms regulated under price cap set efficient prices?
Guma Wau Jr. BEc, BEc (Hons)
Project submitted in partial fulfilment of the requirements for the degree of MSc (Energy and Resources), UCL School of Energy and Resources, Australia.
Electricity pricing structures should allow regulated natural monopolies to recover at least the efficient cost of providing a network service, while also providing a signal to consumers about the costs of consumption.
That is, firms regulated under weighted average price caps must derive network charges on the basis of their standalone and avoidable costs to reflect the cost to connect an additional customer to the network. My research finds that where costs are properly signalled to consumers and where consumers are aware of the price and practically able to respond, consumption should be efficient – this indicates efficient price. Regulated firms show some degree of efficient pricing but to get perfection may not be feasible given the dynamics of the industry.
The research stems from the key question confronting policy makers: do regulated natural monopoly firms set efficient prices?
Conventional economic theory attests that efficient price is achieved when deadweight loss is minimised. This is achieved when firms price at marginal costs. But this hypothesis falls short of reality of a highly dynamic situation where economic interactions are not always in equilibrium. In particular, pricing at marginal cost fails the revenue adequacy criterion. Could it be that conventional economic justification of marginal prices is flawed? Some economists have identified the shortfall of marginal pricing and further set out improvement mechanisms and proposed alternative approaches such Ramsey pricing and two-part tariff as a way to correct the shortfall subject to some theoretical conditions.