Power to the People Threatened
Subject Natural monopoly
Topic Market Failure, Regulation, and Public Choice
Key Words Regulators, rate increases, utilities, prices, costs, deregulation, consumers, bankruptcy, wholesale
News Story

California state regulators have recommended emergency electricity rate increases for Southern California Edison and Pacific Gas and Electric. Although the utilities wanted increases of 26-30 percent, they were only granted 9 percent increases for residential customers. Consumers have already been hurt by higher prices for natural gas. There is also pressure from consumer groups for the utilities to absorb the higher costs.

The issue has arisen because, in the deregulated electricity industry, utilities may buy electricity from other U.S. producers. The booming California economy has required such purchases - and the utilities have had to pay spiraling prices. At the same time, the price they can charge consumers in California has been frozen from 1996 to 2002 by regulators. The utilities claim that they have lost a lot of money and are on the verge of bankruptcy. Their credit ratings are in jeopardy, which could threaten their ability to buy wholesale power and to provide uninterrupted electricity supply. They forecast even greater rate hikes in the next few years.

(Updated February 1, 2001)

1. a) What is a natural monopoly? What is peculiar about its long run average cost curve?
b) Why, in spite of deregulation, can the two utilities be considered natural monopolies?
2. a) Draw a diagram showing the demand and marginal revenue curves, the long run average total cost curve, and the marginal cost curve of Pacific Gas and Electric (PG&E) in 1996. Assuming that regulators intended PG&E to break even, mark the price at which they fixed electricity rates in 1996. Also show the quantity of electricity traded.
b) Since 1996, the Californian economy has grown fast, and utilities have seen rising wholesale power costs. On your diagram, show the implications for the curves and for the quantity of electricity given a fixed price. What has happened to the profits of the utility?
3. Suppose that the emergency price increases result in a price that equals marginal cost. Mark it on your diagram.
a) Explain why this would be allocatively efficient. Why would this be good for consumer surplus and social welfare?
b) Why would PG&E still be unhappy?
Source John Ritter, "Regulators advise electric rate hikes," USA Today, January 4, 2001.

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