The Economics of Tiered Pricing and Cost Functions: Are Equity, Cost Recovery, and Economic Efficiency Compatible Goals?
Document Type Article
The paper develops a framework to analyze equity and economic efficiency of increasing block rates (IBR) for regulated products such as electricity or water. The analytical model assumes that consumers are heterogeneous in their demand characteristics. Conditions are identified under which economic efficiency and cost recovery can be achieved in a manner that also reduces inequality, which is measured through changes in the Gini coefficient of consumer surplus. Under IBR, a utility with significant variability in its marginal costs has a greater ability to improve equity while still remaining revenue neutral and maintaining economic efficiency. Under marginal cost pricing, the Gini coefficient is primarily affected by parameters of the demand function, but with increasing block rate pricing both demand and supply parameters impact this measure. The results are illustrated through the use of a numerical example. (Updated/revised 1-25-2011.)