The economics of tiered pricing and cost functions: Are equity, cost recovery, and economic efficiency compatible goals?

Abstract

The paper develops a framework to analyze equity and economic efficiency of increasing block rates (IBR) for regulated products such as electricity or water. The model assumes that consumers are heterogeneous in their demand characteristics. Conditions are identified under which economic efficiency and cost recovery can be achieved in a manner that also reduces inequality, which is measured through changes in the Gini coefficient of net income. The use of IBR pricing is found to have a limited capacity to address equity issues while maintaining a balanced budget, as the balanced budget limits the size of the tier. Economic efficiency constraints combined with the balanced budget limit the subsidy. The capacity of IBR pricing to modify equity outcomes increases if supply costs are diverse. Under IBR, a supplier with significant variability in its marginal costs has a greater ability to improve equity while still remaining revenue neutral and maintaining economic efficiency. Under marginal cost pricing, the Gini coefficient is primarily affected by parameters of the demand function but, with IBR, both demand and supply parameters impact this measure. The results are illustrated with a numerical analysis of household water consumption from four utilities in the western United States.