The Theory of Water and Utility Pricing - Global Drinking Water Management and Conservation - page 84

In order to apply Ramsey prices, certain assumptions must hold. These are:

(a) The public utility is using the least-cost state-of-the-art technology in drinking
water production,
(b) Such technology is purchased in competitive markets,
(c) The capital-labor ratio in the public utility is optimal, i.e. the one that would
hold in competitive labor markets, and
(d) All inputs, including labor inputs, are purchased in competitive markets.

(d) hold, then the public utility is said to be using the best-
practice techniques. If any of the four conditions does not hold, then appropriate
shadow prices must be computed to

If conditions (a)

-

find the adjusted Ramsey prices. The adjusted
Ramsey prices may be called the shadow Ramsey prices (SRP). The SRP will then
be the benchmark for judging whether the prices that are being charged by a private
sector partner are a social improvement with respect to public ownership or not.
In the empirical literature, it is often claimed that in Canada, the price of water is
well below marginal cost. Renzetti estimates that “ prices charged to residential and

commercial customers are only one-third and one-sixth of the estimated mar-

ginal cost for water supply and sewage treatment, respectively.

…

”

(Renzetti 1999 ,

p. 688). From this, Renzetti concludes that there is a signi cant welfare loss,

associated with overuse of water. His findings can be illustrated in Fig. 5.1 a. The

purpose of the present chapter is not to determine if there is a welfare loss or not,
but to concentrate on the best-practice technique for water production and estimate
the Ramsey price, assuming one user. For the purposes of this paper, the benchmark
is not the actual marginal cost, but the shadow Ramsey price.
Most water utilities in Canada and elsewhere have been relatively isolated from
global water technology and for most water utilities the conditions (a)

(d) would be
violated. This is because they have faced no pressure to cut costs or to adopt new
technology (Brubaker 2011 ). Indeed many did not or could not (for a variety of
reasons) make provisions for capital stock renewal. Most faced unionized labor,
with the result that many facilities were grossly overstaffed. There are other
monopolistic distortions, for which there is ample empirical evidence. The upshot is
that actual market prices are much higher than marginal social opportunity costs.
Shadow prices seek to

-

for these distortions and estimate marginal social
opportunity costs. Hence the actual price, though below actual marginal cost, could
in fact be at or near the shadow Ramsey Price (SRP). This is illustrated in Fig. 5.1 ,
parts (a) and (b). Section 5.6 below is an econometric estimation of Shadow
Ramsey Prices. When taking Shadow Ramsey Prices into account, the statement
that the water selling price is

“ correct ”

“ too low ” (Renzetti 1999 ) can be misleading; such

statements do not take into account the theoretical results of the new public

economics.
In Fig. 5.1 a, the area EFG is Renzetti

'

is welfare loss, due to the fact that actual

price P a is below P b where P would equal current and actual MC, i.e. MC a .In

s model, the breakeven Ramsey price (unadjusted) would be P c , and
optimal quantity supplied would be Q 6 .

Renzetti '