Short-run Marginal Cost Pricing Research Articles

Thought Experiment: Marginal Cost versus John M. Clark’s Workable Competition Pricing

This article compares numerical results for an original model of an industry using marginal cost pricing versus workable competition pricing with fluctuating demand with two alternative technologies. The article is a thought experiment in economics, carried out only in the imagination. The article presents a detailed numerical model of a basic industry, cement manufacturing with large numbers of sellers, cement manufacturers, and large numbers of buyers, the construction industry, operating independently with full knowledge of supply and demand conditions. In the model cement plants have linear total cost functions with absolute capacity limits. The article considers two alternative technologies: 1) plantL old plants with low fixed costs and high marginal costs and 2) plantK new plants with high fixed costs and low marginal costs. This study argues in support of John M. Clark (1884-1963) workable competition theory in contrast to marginal cost competition theory. The study examines likely equilibrium conditions under two alternate pricing systems: a) short-run marginal cost pricing and b) John M. Clark’s concept of workable competition. Workable competition raises prices above marginal costs in the off peak period and lowers prices in the peak periods. The study assumes frequency of off periods 6/7 and frequency of peak periods 1/7. The study claims, under the assumptions of the model, workable competition pricing add to consumer surplus over the cycle.

The technology and cost structure of a natural gas pipeline: Insights for costs and rate-of-return regulation

This note details a complete microeconomic characterization of the physical relationships between input use and the level of output of a simple point-to-point gas pipeline system and uses it to contribute to the public policy discussions pertaining to the economic regulation of natural gas pipelines. We show that the engineering equations governing the design and operations of that infrastructure can be approximated by a single production equation of the Cobb-Douglas type. We use that result to inform three public policy debates. First, we prove that the long-run cost function of the infrastructure formally verifies the condition for a natural monopoly, thereby justifying the need of regulatory intervention in that industry. Second, we examine the conditions for cost-recovery in the short-run and contribute to the emerging European discussions on the implementation of short-run marginal cost pricing on interconnector pipelines. Lastly, we analyze the performance of rate-of-return regulation in that industry and inform the regulatory policy debates on the selection of an appropriate authorized rate of return. We highlight that, contrary to popular belief, the socially desirable rate of return can be larger than the market price of capital for that industry.

The regulatory function in public-private partnerships for the provision of transport infrastructure

A wide range of contractual arrangements are increasingly being used by the public sector to materialise the delegation of transport infrastructure provision tasks to the private sector, over long periods of time. This paper addresses the issue of transport infrastructure regulation in the specific context of public-private settings. Starting by the discussion on the concept of Public–Private Partnership (PPP) it is stressed that, despite the different meanings that can be found in the literature, it is possible to define a PPP by using a core group of characteristics, such as the bundling of services and the transference of a relevant part of the risks to the private sector on a long term basis. Regarding the action of the regulator, we look at three dimensions of efficiency that are expected to be pursued at the strategic level of regulatory action. However, it is acknowledged that the regulatory function is in practice rather complex since it requires balancing a multiplicity of other objectives or goals, which may vary according to specific economic conditions. In the domain of pricing, the review carried out suggests that since “first best” assumptions are not met in the “real world” it hardly seems possible that the short run marginal cost pricing “canon” could be directly used to shape pricing policies. Consequently, when considering the application of the standard neoclassical marginal cost pricing approach it is pertinent to ask whether the second best solutions can lead to efficient outcomes that might be accepted by the stakeholders. Bundling construction and maintenance tasks into a single long term contract, which is a typical characteristic of “standard” PPPs, could theoretically bring cost benefits since it allows for the possible internalization of any positive externalities that may be generated during the whole project life cycle. The economic rationale for the bundling of construction/maintenance with financing services is that it enhances the likelihood of submission of realistic bids at the procurement stage. In addition, the chances of the contractor sticking to the agreed contractual terms, after contract award, are potentially increased given the higher exposure to financial risk.

ECONOMIC FUNDAMENTALS OF ROAD PRICING: A DIAGRAMMATIC ANALYSIS, PART I—FUNDAMENTALS

Parts I and II together presents a conceptual framework for road pricing based on a rigorous diagrammatic—but non-mathematical—framework derived from first (economic) principles. It throws light on congestion pricing systems and issues surrounding short-run and long-run marginal cost pricing, scale economies and diseconomies, indivisibilities, road durability, the peak-load problem in urban transport and the financial viability of the public provision of road services. The paper integrates the ideas of Mohring, Strotz, Vickrey, Walters, Keeler, Small, Winston and Newbery into a single analytical framework. Analysis of the traditional road pricing arguments demonstrates why congestion pricing as practiced in the past has understandably encountered obstacles to implementation. This is partly because both types of road users, the tolled and the tolled off (those who avoid a road in order to shun the toll), are shown to be worse off—with the exception of the government—under a constant value of time. Even if differences in time valuation are taken into account, it is still essentially the case that primarily those with very high time values are made better off. Unless congestion toll revenues are earmarked and travellers perceive that the money is channeled back in the form of reduced taxes, lower user charges or improved transport services, neither the priced nor the priced off would support road pricing. It is only in the case of hypercongestion can congestion pricing be shown to make everyone better off. In the absence of scale economies or diseconomies, the level of economic profits, i.e., toll revenue collections less the fixed and non-use related costs of a road, serves as a surrogate market mechanism indicating that a road ought to be expanded or downsized. The decision to let roads deteriorate over time in and of itself is an act of disinvestment. Further, it is shown graphically that if a road authority were to efficiently charge for congestion, it is possible to make money on the road. Profitable roads arise in urban areas in the long run because land rents are high and congestion tolls reflect the high opportunity costs. Yet, efficient pricing in the presence of both indivisibilities and diseconomies of scale in urban roads may curtail the extent of profitable undertakings, whereas pursuing marginal cost pricing under the restrictive conditions of both indivisibilities and scale economies in rural roads could result in profits in the short run. Economic efficiency would be enhanced if optimal pricing were pursued in the short run and optimal investment in capacity were pursued in the long run. The rule is therefore to implement short-run marginal cost pricing while varying road capacity over the long run. Extensions by Newbery, Small and Winston have enriched the basic Mohring model that this paper develops diagrammatically by incorporating the fact that heavy vehicles are responsible for extensive road damages. Charging for both the external and variable cost of road damages on a vehicle weight per axle basis can help cover the deficit that may arise from congestion tolling. Even if a road network is broadly characterized by increasing returns to scale in road construction's use and strengthening, the deficit could be closed by diseconomies of scope. The existence of scope diseconomies in highways means that a road network that accommodates both loading and traffic volume, as found universally, costs more than the sum of an autos-only and a (smaller) trucks-only road system. Hence, the surplus associated with diseconomies of scope offsets the potential loss associated with scale-specific economies. The viability of a dedicated road or transport fund is enhanced by the fact that the road pavement is charged in two dimensions: once when traffic flow creates congestion and another when traffic loadings cause road damages.

More on scale economies and cities

In this paper we develop a model of a closed economy with many types of traded (between cities) products of which the production functions are subject to scale economies internal to the industry as a whole. Workers are assumed to live in Muth type residential rings and commute to the center of the city where the industry is located. This setup leads to the creation of many types of cities. To each type of city, residential cost functions and output cost functions are constructed. From these cost functions all types of demand functions are derived. It is shown here that the introduction of cities into the economy leads to an equivalence between the demand for inputs and the demand for consumption goods, an equivalence which does not exist in models of economies without cities. Thus there are conditional-compensated, unconditional-compensated and Marshalian demand curves for both inputs and consumption goods. The efficiency conditions for this economy are in the short run marginal cost pricing, and for an interior solution in the long run, average cost pricing is also required. This last condition is equivalent to the Henry George rule. Marginal cost pricing remains an efficiency requirement in the case of natural monopoly cities. Next we investigate two cases of scale economies internal to the individual firms and to the industry as a whole. The first case is a model of regular products in perfectly competitive markets and the other model deals with differentiated products and monopolistic competition. These cases have been previously investigated in the literature. Here we generalize and expand previous results and gain additional insights.

A theory of electricity tariff design for optimal operation and investment

This study addresses the problem of balancing supply- and demand-side operation and investment activities. Existing theory is extended to cover electricity industry models with uncertainty in future conditions and intertemporal linking such as storage and investment. An optimal pricing structure which takes these into account is presented. It would induce participants (suppliers and consumers) to make profit-maximizing investment and operation decisions which are socially optimal. The structure contains two terms: a short-run marginal cost pricing as well as a new incentive term to account for the interaction of participants at different time points. A probabilistic forecast of pricing structures at future time is required. A justification of the result and three simple illustrative examples are given.< <ETX xmlns:mml="http://www.w3.org/1998/Math/MathML" xmlns:xlink="http://www.w3.org/1999/xlink">&gt;</ETX>

Marginal Cost Pricing in Practice

In the late forties and in the fifties a number of French economists connected with Electricite de France were actively engaged in thinking about pricing policy and investment criteria. In contrast to most of their English speaking colleagues, who addressed themselves to their fellow economists, these Frenchmen were concerned to formulate proposals for practical implementation. Thus their work on marginal cost pricing led to the new tariff structure for high-voltage supplies introduced in 1957. Similarly, their work on long-term programming has been directly applied in formulating the investment plans of Electricite de France. In view of their practical importance and intellectual quality, it is extremely valuable to have a selection of these writings brought together and made available to a wider public. Professor Nelson has compiled a most interesting book. It contains, apart from his introduction, twelve chapters (some of them joint products) by a total of seven authors, Marcel Boiteux and Pierre Masse being the who have contributed the lion's share. Chapter 1 offers a bird's-eye view of the economic problems of Electricite de France; the next six chapters deal with price policy, including Boiteux's famous paper on peak pricing; chapter 8 is about the optimal management of seasonal reservoirs, and the last four chapters relate to the choice of investments. There is a certain amount of duplication between some of the chapters, but at least this reassures the reader that he faces a coherent body of doctrine and not a collection of unrelated pieces. In France, the unit-charge of the high-voltage tariff (the tarif vert) varies with time of day, time of year and geographically; in addition there is a peak kilowatt charge. This tariff, which reflects marginal costs, though of necessity only in an approximate way, is given its justification and has its derivation explained in chapters 2 to 7. Many of the complications in the exposition are necessitated by the mixed hydro/thermal character of French electricity supply. The following remarks gloss over these complications in order to concentrate on a key theoretical point in public utility pricing which has bothered a number of writers, namely the relation between longand short-runmarginal cost pricing. The authors' position, as stated by Boiteux, is that provided there is an optimal investment policy, short-term pricing is also long-term pricing and there is no longer any contradiction between the two (p. 70).