Transcript Document
PRICE REGULATION: CEILING PRICES Price Freezes only work for short periods of time (less than a year) Longer term price controls require: *A formula for computing a binding limitation on prices *An automatic adjustment procedure which requires some index that indicates the maximum amount of adjustment that can be made - inflation adjustment formula, - cost justification formula tailored to a specific firm (or group), or - panel of experts that makes ad hoc adjustments *An exceptions, exemptions procedure which places heavy burdens on the firms that are regulated Getting out of controls raises inflation rates *Inflation anticipatory of decontrol *Post control excessive swings before the market readjusts Price Control Formulas 1. Item-by-item price (infeasible quantity) 2. Percentage adjustment based on the inflation rate (inequitable due to different value added) 3. Cost justification formulas (hard to audit or verify) 4. Profit margin (profit-to-sales ratio: inequitable due to different turnover ratios, viz. sales/inventory) 5. Return on investment (profit-to-capital ratio: not computed by most companies and non-standardized measures of capital) CONTROL ON THE RETURN ON INVESTMENT TR-TC K = Permitted rate of return by regulatory commission where TR= total revenue, TC=total cost, K= capital invested The constraint on profit is exercised by the rate base (K). METHODS FOR VALUING THE RATE BASE •Original Cost: the actual cost of the plant is quickly out of date, particularly when inflation is bad does not reflect the obsolesence of the technology •Reproduction Cost: Cost today of the exact same plant who would want to buy out-of-date capacity? hard to get true market value •Replacement Cost: cost today of same capacity to produce output, but using the latest technology. hard to get accurate data on what this cost might be •Fair Value: The court’s attempt to determine how to value the Rate base- usually a combination of original and reproduction arbitrary from one court to the next. CASES DEFINING RATE REGULATION Smyth vs. Ames: The Commission must determine a fair value for the rate base. This value is the province of the court to accept or reject FPC vs. Hope Natural Gas: “If the total effect of the rate order cannot be said to be unjust and unreasonable judicial inquiry… is at an end.” The court defers to the regulatory authority Consolidated Edison Electric Rates: the use of a “test year” for valuing the rate base. INFLATION EFFECTS ON THE RATE OF RETURN: How does inflation affect a firm’s rate of return? CASES: Smyth vs. Ames: “fair return” Hope Natural Gas: “the return to the equity owner should be commensurate with returns on investments from other enterprises having corresponding risks” Consolidated Edison Electric Rates (1973) provided an explicit example of the setting of rates MADISON GAS AND ELECTRIC RATE HEARING: •Three types of charges- demand, customer, and commodity •The customer should be charged the cost he is responsible for •Long-run marginal tests are the basis for determining rates KEY QUESTIONS ABOUT REGULATING PRICES What prices can’t the Regulatory commission Control? What prices can it control? What is the effect of depreciation on a firm’s rate of return? What is the effect of regulatory lag (Commission does not adjust prices quickly enough?) How is the rate structure determined? • Why is price discrimination necessary for some public utilities? • Does price discrimination by the public utilities contradict antitrust purposes?