Professor,
What do you
mean by
the term
“regulatory
dilemma”
I refer to the dilemma
confronting regulators
(e.g., public service
commissioners) as they
go about the task of
subjecting firms covered
by their legislative
mandate to rate-ofreturn regulation.
We will use some simple graphs to
illustrate that marginal cost pricing
will, in the case of sustainable natural
monopoly, saddle the regulated firm
with losses. The Courts have ruled that
the regulated firm must receive a
return on shareholder equity that is
“fair.”
$
Case 1: Unregulated Monopoly

PM
CM

D = AR


LMC
MR
0
QM
LAC
QC
MWHs
$
Case 2: Marginal Cost Pricing
D = AR

C1

PC
LMC
MR
0
LAC
QC
MWHs
Hence:
•Option 2 is optimal
on social efficiency
criteria.
Recall the necessary
condition
for socially efficient
resource
allocation:
P = MC
•Why not select option
2 and subsidize the
regulated firm by amount
C1PC?
Subsidies give rise to problems of
distributional equity. For example, suppose
that gas companies were subsidies from general
tax revenues—does this not amount to an income
transfer to gas customers from tax payers that
are
all electric”?
$
Option 3: Average Cost Pricing

PA


LMC
MR
0
LAC
QA
MWHs
Comparing the results
Dead
Weight
Loss
Option Price Quantity given by
area
Econ
Profit given by
area
1
PM
QM

PMCM
2
PC
QC
0
(C1PC)
3
PA
QA

0
In summary, option 2 is superior on social
welfare grounds—but fails to
produce a fair return for the regulated firm.
Option 1 certainly gives the regulated firm a
hefty return, but fails badly on welfare
grounds. Option 3 is a “compromise”
and is best in terms of reconciling two
objectives—i.e. maximization of the total
surplus
and the necessity to provide regulated firm a
fair return