Energy is one of the necessities for human beings, of which provision is a natural monopoly because of its industry characteristics. An unregulated natural monopoly would not consider maximizing economic welfare, in other words, protecting consumer interests regarding price, output, and innovation. Therefore, regulators step in from outside the market. In this case, the Irish energy regulator states its mission to be: “ensure that: the lights stay on, the gas continues to flow, the prices charged are fair and reasonable, the environment is protected, and, energy is supplied safely.” However, it is uncertain if this is consistent with an objective to maximize economic welfare when the regulator’s actions are not clarified. This essay is going to analyze the CER’s mission, then show how compatible it is with the objective in different scenarios.
The mission can be divided into three parts. The first part is maintaining the utilities (electricity and gas) produced and supplied “the lights stay on, the gas continues to flow,” for which there is much rationale. Since there is a lack of competition, firms don’t have the incentive to advance the quality to enhance demand, especially when consumers do not have sufficient information to assess the value of service. Consumers either over-consume, under-consume or pay high prices for substandard services, which reduces consumer surplus and further reduces economic welfare. For example, in my home country in Vietnam, there are frequent electricity cuts, which affects everyone’s work and life; however, there is only so much consumers can do as they can’t choose from an alternative provider. Here, the CER acts as a consumer advocate/ protector by evaluating the quality of the service being provided and the value of that service to consumers. In addition, CER will want monopolistic firms to produce the maximum outputs for given inputs to achieve productive efficiency.
On the other hand, nothing will be produced if firms can’t stay in business. An unregulated electricity company wants to produce at the level where marginal revenue is equal to marginal cost. However, the price it charges is higher than marginal revenue, which means that marginal cost is less than price. Allocative efficiency is not achieved as too little service is produced at too high of price that some “vulnerable” consumers cannot afford. So regulators may set a price ceiling for electricity at the level where the price equals the firm’s marginal cost. However, a dilemma arises when firms aren’t able to recover the capital sunk at the beginning, for price falls below average total cost which declines over a wide range of output. As a result, firms bear losses and get out of business.
In the past, governments have set a price ceiling where price is equal to average total cost; firms earn normal profit, just enough to maintain in the long-run and this is a break-even price. Another solution is Ramsey Pricing. Prices are differed for each individual, but all raised above marginal cost, depending on their service’s price elasticity of demand. Those whose demand is more inelastic would pay higher than those whose demand is relatively more elastic. This price structure seems to be more economically capable, but it touches on an issue of fairness. Customers with relative higher inelastic demand usually find difficulties in seeking substitutes. Thus the service for them is more necessary or vital. Charging them higher entails social unfairness, hurting consumers in aggregate, and violation of the very principle objective. In short, if “the prices charged are fair and reasonable” was to be consistent with maximizing economic welfare, the CER would need to ensure that energy service is accessible and affordable to everyone and firms continue to operate.
It is not sufficient to maximize economic welfare when dynamic efficiency is not reached. Once technological innovations take place, firms can allow for more output production for a given level of inputs, or the same level of output to be produced for lower level of input. Not only dynamic efficiency shifts out the PPF curve and shifts down the ATC curve, it can also introduce better environmental protection and safer supply – the third part of CER’s mission. Nevertheless, regulated firms cannot pursue this ideal unless patent protection is available and potential monopoly profit is earned to reward the huge upfront R&D costs. Noticeably, as discussed above when governments set a price ceiling (P=ATC), firms are breaking even, and, thus, have no income to invest in R&D. Therefore, allocative efficiency, delivered to consumers particularly, necessitates potential monopoly profit to be temporary; otherwise to observe outcomes consistent with those in a perfect competitive market, governments might need to subsidise R&D for firms’ innovations.
“The environment is protected, and, energy is supplied safely” also means taking negative externalities into account and protecting lives and assets. If there were to be environmental contamination, i.e. oil spill, or accidents, i.e. gas pipe line, society would bear massive costs, which directly reduces economic welfare.
In the end, CER’s mission is consistent with an objective to maximise economic welfare in theory. Nevertheless, to achieve this, CER must take great consideration of which actions to take to deliver the best outcomes observed in a perfectly competitive market.