Alternative concepts of marginal cost of   public utility pricing : problems of application in the   water supply sector

Saunders, R.; Warford, J.; Mann, P.

Alternative concepts of marginal cost of public utility pricing : problems of application in the water supply sector

Saunders, R. | Warford, J. | Mann, P.

This paper discusses the rationale and problems of implementing marginal cost pricing for water supply and sewerage facilities. Many of the issues are now fairly well known; however, there remains one critical area in which ambiguity remains. This stems largely from the different ways in which economists have tried to handle the problem of capital indivisibility, for which, by definition, marginal analysis is not well equipped. The paper examines several frequently used definitions of marginal cost. Using a number of assumptions about long-term trends in costs, output and capital indivisibility, it evaluates each approach according to its implications for year-to-year price fluctuations, economic efficiency and revenue generation. As a result of these performance tests, the judgement is made that it is not possible to establish a set of precise marginal cost estimation rules which can be followed mechanically in all circumstances. In practice, compromises are required, and the types of compromise that are suitable depend upon the degree of capital indivisibility, the stage of the project and program cycle at which the pricing decision is being made, the relevant elasticities of demand, and, not least, the prices which currently prevail.

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