Introduction

In this chapter we bring together the demand side and the cost structure of the regulated firm to start on our main theme: efficient pricing by the regulated firm for its services. The discussion is designed to bring out the main concepts as clearly as possible. These concepts are:

1. – Efficient prices are those which lead to the highest possible level of welfare, defined as the sum of consumer surplus and producer surplus.

2. – Moving from some given set of prices to efficient prices makes it possible for the “winners” from the price change to compensate the “losers” and yet still remain better off than before the change. Thus, potential economic welfare rises for all individuals.

3. – If the regulated firm must break even out of its own sales revenues, potential welfare of society is lower than if the regulated firm were not required to break even.

We first discuss these points in a simplified scenario where the demands for the services of the regulated firm are independent of each other, and where marginal costs are constant. Subsequently, the analysis is broadened to include cross-elasticities of demand between services and to consider non-constant marginal costs. The discussion will cover marginal cost pricing, so-called Ramsey pricing and the accounting-based methods known as Fully Distributed Cost (FDC) pricing. In addition, we will discuss the literature on cross subsidy and the recent axiomatic approach to the allocation of common costs.