A Curious Solution to the Problem of Optimal Price Regulation.

Setting an optimal price for a decreasing-cost privately owned "public utility" has been a persistent problem in welfare economics. On the one hand, if price is set equal to marginal cost of production, the utility must be subsidized. This subsidy may entail undesired welfare redistribution. On the other hand, the subsidy may be eliminated by setting price equal to average cost, but then necessary conditions for efficiency in the sense of Pareto may not be satisfied. A curious but rather special solution to this problem was suggested by a recent electric company advertisement. Where the utility had previously claimed that "electricity is penny cheap-costs less than it did thirty years ago," the new campaign offered an explanation, electricity is cheaper today because "larger consumption means larger plants and more efficient production." Since the elasticity condition is obviously sufficient as well as necessary, the following conclusion can be arrived that the static analogue of the new steady state satisfies necessary conditions of Paretian efficiency if and only if the elasticity of demand by each consumer for the utility product with respect to its regulated price is the same for all consumers in a neighborhood of the steady state consumption.