WELFARE ECONOMICS AND THE THEORY OF OPTIMUM PUBLIC UTILITY PRICING AND THEIR PRACTICAL APPLICATION WITH SPECIAL REFERENCE TO FEDERAL TRANSPORTATION POLICY DISSERTATION Presented In Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of The Ohio State Universi ty By Thomas Anton Martinsek, A. B., M. A The Ohio State University 1956 Approved by: Adviser Department of Economics TABLE OP CONTENTS Page LIST OP ILLUSTRATIONS v. Part One WELFARE ECONOMICS AND EQUILIBRIUM CONDITIONS Chapter I. INTRODUCTION . <.......................... 2 II. ECONOMIC WELFARE CRITERIA .................... >■ 8 The Nature of Welfare Economics: The Social Welfare Function Efficiency of Production and Consumption: Marginal Conditions for an Optimum Reorganizations: The Compensation Principle Welfare Measures To Be Used in the Study III . LAWS OF COSTS AND R E T U R N S ....... 44 Firm Cost Patterns Industry Supply Patterns Summary and Conclusi ons IV. EQUILIBRIUM CONDITIONS AND MAXI MUM WELFARE... 84 Equilibrium of the Firm Equilibrium of the Industry Summary and Conclusions Part Two THE THEORY OF PUBLIC UTILITY PRICING V. THE CRITERIA FOR PUBLIC UTILITY CLASSIFICATION ................................. 122 The Legal Criteria for Public Utility Regulation An Economic Criterion for Public Utility Classification Existing Public Utility Control In the Light of the Postulated Economic Definition VI, THE DETERMINATION OF LONG-RUN PUBLIC UTILITY PRICES ................................. 147 The Possible Choices Payments Necessary with Marginal-Cost Pricing Conclusions ii Chapter - Page \ VTI. THE SHORT-RUN AND OTHER PROBLEMS. S OP PUBLIC UTILITY PRICING . .'................ $. 178 Short-Run Public Utility; Pricing New and Expanding Industries Dyinp; and Contracting Industries Conclusions Part Three THEORY AMD PRACTICE IN PUBLIC UTILITY REGULATION VIII. PRA0TICAL PUBLIC UTILITY REGULATION: FEDERAL TRANSPORTATION REGULATION POLICY .... 206 The Goals of Federal Transportation Regulati on Federal Public Utility Price Setting Poli cy Conclusions IX. USE OF THE THEORETICAL CONCEPTS I N 'ACTUAL PRICE SETTING........... '..................... 241 Measurement of Cost and Demand Functions Guaranteeing the Efficiency of Operations Collection of the Tax and Payment of the Subsidy Market Imperfections and Marginal-Cost Pricing Standards for Investment Summary on Practical Application of the Theoretical Tools X. SUMMARY, CONCLUSIONS AND RECOMMENDATIONS ___ 260 APPENDIX A ....................................... 269 BIBLIOGRAPHY............................................. 273 111 LIST OP ILLUSTRATIONS Figure Page 1. Utility Surfaces ................. 22 2. The Production Function ......................... 47 3. Increasing Costs to Scale ...................... 55 4. Constant Costs to Scale . ..................... 56 5. Decreasing Costs to Scale ................. 57 6. Industry Cost Patterns .......................... 74 7. Increasing Costs to Scale ...................... 88 8. Decreasing Costs to Scale ...................... 92 9. Constant Costs to Scale .......... ‘............ 99 10. Increasing Industry Costs .................... 103 11. Constant Industry Costs .................... 108 12. Decreasing Industry Costs ....................... 113 13. • Marginal-Cost Pricing .......................... 150 14. Average-Cost Pricing ............................ 157 15. Tax on Public Utility Consumer .............. 163 16. Increase in Consumers' Surplus ................. 167 17. Short-Run Marginal-Cost Pricing ............. 180 13. Short-Run Average-Cost Pricing ........ 187 19. Average-Cost Criterion for Increased Investment ...................................... 197 iv PART ONE WELFARE ECONOMICS AND EQUILIBRIUM CONDITIONS 1 CHAPTER I INTRODUCTION The logic of public utility pricing Has significance for more than the pricing of public utility services. The same logic applies to control of prices in general. The problems of general pricing controls, however, lie outside the scope of this study. Only public utility pricing in an economy characterized by a minimum of control will be con­ sidered. Three basic questions will be considered. The nature of the industry which Is to be regulated will receive first consideration. It will then be possible to examine the na­ ture of the regulation. The economic logic of placing In­ dustries under control and of the regulation also will be compared with transportation regulation policy on the fed­ eral level In the United States. Natural monopoly conditions will be the subject covered in Part One of the study. Attention will be directed at the cost conditions which would result in a breaking down of op­ timal equillbriiim conditions in unregulated markets. Such optimal equilibrium conditions will be derived from contem­ porary economic welfare theory. Put in another way, Part One will examine cost patterns to determine the types of cost patterns which would lead to non-optimal conditions in unregulated markets. Cost patterns and the physical produc­ tion conditions which a firm might encounter will be consid­ er 3 ered, as will industry cost patterns. Firm and industry cost patterns then will be viewed from the standpoint of possible optimal equilibrium conditions. Part Two will consider public utility pricing. An at­ tempt will be made to set up a definition of public utility consistent with the welfare standards. The legal definition will be compared with the economic definition. Having con­ sidered cost structures leading to a collapse of optimal equilibrium, applicable welfare standards and the definition of public utility, the problem of the pricing of public utility services can be examined. The pricing of public utility services will be broken into several areas. Long- run pricing and short-run pricing will be of greatest impor­ tance. New and expanding industries also will be examined, as will contracting and dying industries. Standards appli­ cable to pricing and investment will be the point of empha­ sis in the examination of these areas. The last major area to be brought into the study will be the practical considerations Involved in public utility price setting. Practical problems involved in the applica­ tion of price setting standards developed from theoretical economic concepts will be examined. The feasibility of the use of theoretical concepts in actual regulation will be of major concern. The goals and pricing standards of federal public utility regulation as evidenced by the pertinent statutes and Supreme Court decisions dealing with federal 4 transportation regulation policy also will be examined. Comparison of these goals and pricing standards with econom­ ic standards will receive major attention. The possible contribution of economic analysis to public utility price setting will be developed from the comparison. Static concepts and standards will be used in this study. In the investigation of the cost structures, con­ ventional static cost theory will be the basis of consider­ ation. Similarly, the welfare standards will be those suited to the evaluation of static equilibrium conditions. Use of static standards in a dynamic world results in in­ adequacy of treatment and gives rise to shortcomings in ap­ plication. However, dynamic theory in economics at the pre­ sent time is either of too sketchy a nature or inapplicable to the problems under consideration in this study. Great difficulty arises just in the definition of eco­ nomic dynamics. To some people dynamics is apparently a synonym for good. Others define dynamics as arising when expectations are included in the analysis. Another defini­ tion applies the term dynamics to analysis in which every quantity is dated. Emphasis on time lags is the essence of dynamics to some. The nature of the achievement of equi­ librium is used at times as another definition. The secular growth of the entire economy in a macro-economic sense is the basis for the development of a substantial body of liter- 5 ature at the present time.-*- -*-Por a discussion of various definitions of dynamics, see R. P. Harrod, Towards A Dynamic Economics, (London: Macmillan & Co., 1949), pp. 1-20. Of the approaches mentioned above, the area of greatest advance in dynamic theory has bean with the macro-economic concepts of total output, employment, and price levels which are not suitable for application to the basic problems of this study. Attempts at rigorous consideration of the dy­ namic aspects of the prices and outputs of individual com­ modities have been much less successful. They usually de­ pend on the postulating of special conditions such as lags in the response of producers to price changes used in the Q cobweb theorem. Dynamic welfare analysis is quite sketchy, Ezekial, ,TThe Cobweb Theorem,” Quarterly Journal of Economics, Vol. LII (1937-58), pp. 255-26-SO. emphasizing the movement toward an equilibrium position.^ ^See, M. W. Reder, Studies in the Theory of Welfare Economics, (New York: Columbia University Press, 1947), pp. 103-177. In view of all the difficulties of applying the exist­ ing body of economic dynamic theory to the problem of public utility pricing, there.is little choice but to carry the analysis on a static level. One other alternative exists, 6 of course. The alternative is to develop a theory of eco­ nomic dynamics within the study itself. This is ruled out for two reasons. The development of a dynamic theory, if possible, would be a task in itself, overwhelming the con­ fines of this study. It is also impossible to say whether