Coping With Drought:
Politically Workable Marginal Cost Water Pricing
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Economist Darwin Hall helped design a politically successful marginal cost pricing schemes. A low price is charged for peoples’ basic needs such as showers, toilets, cooking, and drinking. But for less‐essential uses like car‐washing, sidewalk hosing, street watering, leaky pipes, and landscaping, water is priced at marginal cost. Marginal cost pricing signals the real cost imposed on other people (opportunity cost) of non‐essential water uses. His pricing scheme accomplishes three things
(1) it moderates the burden of the drought on low income households and on necessary uses,
(2) it signals the real cost of luxury uses,
(3) during droughts it can be tailored to produce enough revenue to pay for total costs, whereas average cost pricing produces revenue shortages. Your mission is to use Dr. Hall’s method to set up a program for managing a potential drought in New Mexico.
Suppose Albuquerque water customers normally use 100,000 acre feet of water per year when all water is priced at an average cost of $300 per acre foot (about $1.00 per thousand gallons).
A forthcoming drought is anticipated to reduce capacity to 80,000 acre feet, so Albuquerque customers must use 20,000 acre feet less. Suppose the price elasticity of demand is estimated at ‐0.20: each 1 percent increase in price reduces use by 0.20 times that 1 percent change, or two‐tenths of 1 percent.
Algebraically, this says ɳ = (ΔQ/ΔP) (P/Q) = ‐0.20, where
e = price elasticity (0.20)
ΔQ = necessary conservation (20,000 acre feet)
ΔP = necessary increase in price to eliminate deficit (you need to calculate)
Q = normal quantity of water use (100,000 acre feet/year)
P = current price of water ($300 per acre foot) = average cost of supply = $300/acre foot.
1. Use the elasticity formula to calculate what tail block rate (figure in class slides) that eliminates the deficit. Explain how you can interpret this price as the marginal cost of water in a drought?
2. Suppose total annual cost of operating Albuquerque water supply is $30 million, whether or not there is a drought. So average cost is $300 per acre foot when capacity is 100,000 acre feet, or $375 per acre foot when capacity is 80,000 acre feet. Total revenue must always equal total cost, a requirement assigned to the Public Utility Commission. The City Council is elected, so they want to charge the low base price of $300 for as many acre feet as possible before raising the price to your calculated level at the break point. They want to extend the break point as far to the right as possible in the figure. At what break point should the price be raised from $300 to the politically negotiated rate of $100 per acre foot so that total revenues from the sum of total revenue equals the sum of total costs? Explain.
3. Show that your two part pricing scheme produces exactly enough revenue to cover total costs
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