Economies of Density and Size in the Production and Delivery of Electric Power

Abstract

Recent proposals for regulatory reform in the electric power industry have emphasized the potential for competition among generating facilities but have been less optimistic about the role of market forces in the delivery of electric power. The possibility that there exist significant scale economies in the transmission and distribution of electricity has led to arguments that all, or some, of the components of the delivery system should continue to be regulated regardless of any regulatory changes at the generation level. While the technology of electric power generation has been examined in detail, the magnitude of scale economies in the transmission and distribution of electricity is less clearly understood. The difficulty with analyzing scale effects in industries which deliver a product to a spatially dispersed group of customers, such as electricity, cable television, water, or natural gas, is that output expansions can occur in several different ways. Increased demand by existing customers, demands by new customers within the firm's service area, or an expansion of the service area can all lead to increased output but each can have a different impact on unit cost and thus lead to a different measure of scale effects. This paper develops three measures of economies of density and size which are useful in analyzing the cost structure of firms which must deliver their output to geographically dispersed customers. The measures, which recognize the different ways in which output changes can occur, are used to analyze firm differences in the average cost of supplying electric power. The empirical results indicate that the important source of declining ray average cost is an increase in the quantity of output consumed per customer and not an increase in customer density or service area size. On average, a 1 percent increase in output, holding both the number of customers and service area fixed, leads to a .82 percent increase in total cost. If the increased output results from an increase in the number of customers, as would happen in an area with a growing population, there is no substantial decline in the average cost of delivered power. A one percent increase in both output and number of customers, which keeps consumption per customer constant, results in a .98 percent increase in total cost. On average, there are no significant economies resulting from increased customer density. This occurs because the decline in average cost due to the increase in output is offset by an upward shift in the average cost function resulting from the increase in the number of customers. One implication of competing firms in a given service area is a decline in customer density and this finding suggests that substantial efficiency losses would not occur as a result.