The Theory of Water and Utility Pricing - Global Drinking Water Management and Conservation - page 85

(a) (b)

$ $

AC a

Zero Subsidy Prices

M

P c MC a Breakeven Price

P 2 AC*

E

P b H

F

K MC*

P a P 1 * N

G J

D

D

0 Q 6 Q Q 5 Q 3 Q 2 Q 1 Q

Q 4

Fig. 5.1 The econometric estimation of Shadow Ramsey Prices

However if AC and MC are evaluated at the required shadow prices and
therefore take into account market distortions due to monopolistic markets for
capital goods, unionized labor, etc., then P a may be close or even equal to P 1 *, the
Shadow Ramsey Price SRP * , shown in Fig. 5.1 b. In this case, imposing the price
P b , where price is equal to actual marginal cost MC a would involve a welfare loss in
the opposite direction. This loss is the area HJK in Fig. 5.1 b. Moreover, imposing a
Breakeven Price P c in Fig. 5.1 a would result in a very large welfare loss equal to the
area MNK.
The observations above yield the following conclusions:

1. Just because actual (current) price is below actual MC does not necessarily mean
that there is a welfare loss.
2. The policy conclusion from Fig. 5.1 a, that price should be raised at least to P b is
also not valid.

A more general conclusion is that the priority when dealing with public utilities
should be cost reduction through better technology, better management, and a
reduction in labor input, rather than the price increase. This general conclusion is in
line with the objectives of the legislation of the Ontario government that requires
water utilities to become independent financial entities and raise revenues to cover
all of their costs, including capital costs. The Ontario Clean Water Agency
(OCWA) was created on November 15, 1993 under the Capital Investment Plan Act
with a mandate to provide reliable water and wastewater services to Ontario