I came across an excellent paper on utility economics the other day during some internet research. The paper stands out for its focus on regulation of natural monopoly businesses, which specifically include water and sewer utilities. Natural monopolies are defined as an industry where a single firm can produce output to supply the entire market at a lower per-unit cost than can two or more firms. Such firms tend to be subject to price regulation, which includes water rates and sewer rates.
The paper (attached for download here) is written by Ben W.F. Depoorter, a law professor at the Universeity of Ghent. At pages 8 and9, he accurately describes the problem of setting prices (i.e. rates) for natural monopolies, which include water and sewer utilities, at the point where P = Marginal Cost (MC). At such a price, however efficient, is at a point that is less than the total average cost and therefore cannot be sustained. Pricing at that level would cause the firm in question to go out of business.
Going out of business is an undesirable option for community drinking water and wastewater systems, to say the least. What the paper doesn’t discuss fully is the notion that natural monopolies might be regulated under two different models, both of which achieve similar regulatory results with respect to pricing. Under one model, the private firm is allowed to operate as a monopoly within a defined service area and government regulates the firm’s prices by direct oversight. Such is the case with many electric distribution companies, and natural gas distribution companies. Those firms, while privately owned, submit to public utility commissions their proposed changes in price (i.e. rates) for approval.
Another regulatory model exists where prices are set directly by governments, as is the case with most community drinking water systems and wastewater systems. Such regulation occurs by direct ownership by government rather than by oversight. In the direct ownership model, government literally owns the utilities and its elected officials determine pricing.
Both models will tend to produce the same overall results with respect to pricing at or toward average costs mostly due to the reality of the natural monopoly relationship discussed in the paper at length, and summarized above. That’s not to say that the costs of private utilities and government-owned ones are equal. Far from it. In a previous blog, we have described how private utilities tend to cost consumers more than do the ones owned by government. The point here is only that natural monopolies, even those owned by government, are not generally free to set prices wherever they please.
Regulation of Natural Monopoly, by Ben W.F. Depoorter
More Private Water Company Rate Problems, StepWise blog
Corporate Water Utility Rates – Show Me the Efficiencies, StepWise blog
Natural Monopoly – Wikipedia
What is “subadditivity” in a Natural Monopoly? - Wikipedia