SOME IMPLICATIONS OF DYNAMIC DEMAND FUNCTIONS FOR PUBLIC UTILITY PRICING AND REGULATORY POLICY

Dynamic functional forms are used extensively in the empirical estimation of the demand for services provided by public utilities. Also, there is evidence that some of the ad hoc pricing rules advocated for use by public utilities may have been motivated by an implicit recognition of the dynamic demand phenomenon. However, little has been done to incorporate the concept of dynamic demand in the theory of the regulated firm or in the main body of applied welfare economics.;The model is formulated as an autonomous, infinite horizon optimal control problem. An analysis of the first order necessary conditions indicates that, under steady-state conditions, a policy of marginal cost pricing should be followed. Furthermore, examination of the Euler equation for the equivalent problem in the calculus of variations reveals that a policy of marginal cost pricing should be followed even when steady-state conditions do not prevail.;The basic model is modified by adding a breakeven constraint to produce a dynamic version of the well known Ramsey pricing rule. A comparison of the dynamic rule with that derived for the static case indicates that significant errors can result if the latter is applied in cases where demand exhibits a dynamic structure.;Finally, some implications of the dynamic demand phenomenon for the regulation of public utilities are considered. It is shown that, if two utilities serve markets with equal short-run price elasticities, but one market has a dynamic demand structure and the other does not, then the difference between profit maximizing prices and Ramsey-optimal prices will be smaller in the dynamic market. This suggests a policy of relatively greater regulatory oversight of public utilities which serve static, or more weakly dynamic, markets.;A measure of intertemporal consumer surplus is used to formulate the objective function in a model of a welfare maximizing public utility which serves a market with a dynamic demand structure. An important advantage of the model structure utilized is that it specifies dynamic demand using the same distributed lag functional form as is often used in empirical work.