| The goal of this study is to improve our understanding of the promise and problems connected with the practical application of marginal cost pricing approximations in the water supply field. After a brief introduction to this question, a background discussion is provided on the theory of efficient utility pricing in the presence of scale economies, peaking problems and concern for equity.;This theory depends on well-defined capital cost functions, while the real world provides, at best, sets of discrete investment alternatives that define a particular utility's expansion path over some planning horizon. To deal with the reality, several marginal cost pricing approximations have been developed, and four of these are examined in the study: "textbook", Turvey, "average", and "proxy". The examination compares their performance in the context of the Phoenix, Arizona, water utility and its expansion plan through 2010. Three criteria are of major interest: price stability year-to-year; revenue adequacy; and economic efficiency (in which credit is given for the consumer surplus associated with water supply). Two contrasting demand functions and three interest rates are used.;The first comparisons take the Phoenix plan as given in terms both of investments and of their timing. In order to maintain an economically level playing field, however, it is necessary to find, for each approximation, demand function, and interest rate, the optimal capacity expansion path. This is done using a specially constructed dynamic programming algorithm. The results of the comparisons may be summarized briefly as follows:;All four approximations, operating on their tailored optimal expansion paths, produce efficiency gains of about 10 percent over the current Phoenix pricing scheme. The ordering of gains, from greatest to least, is;Price variability is greatest for the proxy and least for the average marginal cost approximation.;Under some parameter and assumption combinations, the textbook and proxy approximations do not yield adequate revenue to pay for capacity additions and operations. Turvey yields enormous surpluses that would have to be returned to consumers. The surpluses associated with the average marginal cost approach fall roughly halfway between textbook and Turvey.;On balance, average marginal cost pricing looks most promising, but since the four formulae are essentially arbitrary in any case; it seems worthwhile to search for other versions that might perform even better. |
