2 - Defining a Theoretical Normative Benchmark

Summary

The common economist’s benchmark to assess the efficiency impact of a regulatory decision is to compare the output and price outcomes of this decision to those that would be achieved under marginal cost pricing. The chapter explains that the efficiency payoff of marginal cost pricing in public service industries has to be balanced against the financial losses from this pricing strategy. It is because the average cost of production is usually declining over a substantial range of output and the marginal cost is below the average costs that marginal cost pricing leads to financial losses. It is this existence of increasing return to scale that explains why public service operators are often labelled as natural monopolies. The associated market power is what makes regulation necessary to ensure that these monopolies do not under-provide the services and/or overcharge. The chapter explains that to minimize the risk of abuses, regulators need to get precise assessments of the elasticity of demand to prices and income and of cost functions since these are needed to be able to measure efficiency outcomes.