USING A HYPOTHETICAL EFFICIENT FIRM TO BENCHMARK WATER UTILITIES IN CHILE

Abstract

Natural monopoly regulation should ideally meet the objectives of inducing firms to produce the socially efficient quantity (allocative efficiency), inducing the firms to produce at minimum cost, (productive efficiency) while letting the firm to obtain enough revenues so as to cover its costs.1 Since 1989, the regulatory scheme established in Chile for price setting in electricity distribution, local telecommunications and water supply has been one based on the construction of a hypothetical efficient firm to benchmark utilities.2 Unlike the yardstick schemes used in countries like, for example, the U.K., in which the reference used for benchmarking is the behavior of existing firms (using their average behavior or the behavior of the most efficient one), the scheme used in Chile uses as a benchmark a hypothetical firm.3 The latter is commonly refered in the Chilean legislation as model firm4; term that we will retain in what follows. This model firm is supposed to produce the quantity demanded by the market at the minimum cost that is technically feasible, given predefined quality standards and available information. The scheme separates the costs used for price determination from the firm’s real costs, so that it will only be able to obtain a normal return if it behaves according to the model firm. Thus, any “inefficiencies” (i.e., costs higher than predicted by the model firm) will not be passed through to final consumers but borne by the utilities, which in most cases are private entities. In this sense, the mechanism offers the advantages of an incentive based mechanism while maintaining some of the characteristics of the rate of return regulation (Newbery (1999)).