-60 elastic, price reductions will actually increase total revenue. If this increase in total revenue exceeds the increase in total costs -- i.e., exceeds complete incremental costs - it will improve the revenue-cost relationship. Thus, where a firm provides both demand-elastic and - inelastic services, such a reduction in the price of the demand-elastic service may, by improving the revenue-cost relationship, actually reduce the burden of costs on other services. Similarly, an increase in the price of a demand-elastic service may increase the burden of costs borne by the other services. Assume, for example, that the demand for a service is quite elastic, and that rates are increased in a misguided effort to improve return on allocated historic investment. The result ant loss of business usage and revenues - must be compared with the reduction in costs resulting from this loss in volume. With high fixed costs (a characteristic of utilities), it is not improbable that the revenue reduction will be greater than the cost reduction, i. e., there will be a decline in net revenue. This would increase the cost burden in a never-ending cycle if the process of rate in on other services - creases for that service were repeated. Assume, on the other hand, that rates for the demand-elastic service are reduced even though revenues are already below "cost." If volume increases sufficiently, unit costs may be so reduced that the new, lower rates will prove remunerative, and the company will have launched what some term "a growth cycle" of higher consumption-lower costs-lower rates. -61 If demand for all services were inelastic, any reduction in the price of one would necessarily impose burdens on the others since a price cut would reduce total revenues while tending to increase total costs to the extent that volume rises. Under these circumstances, pricing policy under regulation becomes a matter of balancing equities, not 331 of achieving gains in efficiency· that benefit all customers. At least some utility services, however, generally face substantial competition, and therefore may not face inelastic demand. Where some demands are elastic, pricing policy is an available and necessary tool for achieving economic gains for all customer groups. Let us consider a situation in which the demand for one of the services is price-inelastic, and the demand for the other is not. The price for the service having the elastic demand should in any case be no less than the complete incremental cost of providing the service. The ideal price for that service should be that which would maximize the total dollar difference between the additional revenue and the complete incremental cost (including return) of the added service. This price would result in a maximum contribution to the carrying costs of the 33/ In this instance a gain in efficiency requires that at least -62 investment in common plant and to company overhead, in addition to an adequate return on the additional investment. In the case of the service having the inelastic demand, however, rates should be set with reference to the systemwide rate-of- return requirements. Note that an increase in the price of the demand-elastic service will actually decrease the total revenues generated by that service, and if this revenue decrease is greater than the total decrease in costs, there will be a net increase in the cost burden to be borne by the inelastic service. Thus, the final result of increasing the price of the elastic service would be to necessitate a price increase for the inelas tic service as well. Assume, for example, that the demand of large industrial customers for electric power is highly elastic while the demand of small residential customers is not. An increase in industrial electric rates would, under these assumptions, decrease the revenues obtained from those customers, since usage would decline more than rates had increased. If this revenue decrease were greater than the decrease in costs, a greater cost burden would have to be borne by small power users. Thus, industrial rates which yield a lower return on fullyallocated costs than do electric lighting rates to residential customers are not, in this example, in any sense "unfair" to the latter. -63 Assume next that it is possible to arrive at some sensible method of allocating historic costs to each service, and that a utility's rates are yielding the same return, at the permitted level, on allocated net investment in each service. This would be far from the best of all possible worlds for customers with presumably inelastic demands such as electric lighting and small power customers. For, if demands for other services are price-elastic, rate reductions for those services might very well result in rates for the inelastic-demand customer which would actually be lower than if all customers' rates were based on fullyallocated, historic costs. So long as the additional revenues cover the complete incremental cost of providing the demand-elastic service, including the permitted rate of return on the total incremental investment, that service improves profitability and reduces the revenue burden on the residential lighting customer. In fact, if a decrease in rates for services offered to customers whose demands are price-sensitive could result in a decrease in the cost burden borne by other customers, insistence on the target return on all services would, in effect, be subsidizing the utility's competitors! As services are added, the apparent rate of return on historic net investment allocated to the inelastic-demand service may, indeed, rise; but the dollars of return from those customers will decline. This is because the added services make possible fuller utilization of -64 the common plant serving them and the other customers. Since the adde: services are priced to cover the complete incremental costs associated including a portion of the cost of common plant added - they reduce the investment costs to be borne by the other customers, and the dollars of return required thereon. C. Utility Cost Economics The decreasing-cost nature of the electric The decreasing-cost phenomenon characteristic of electric utilities is another economic factor which must be grasped in order to understand the nature of utilities' responses to the competition described earlier. There are three aspects of decreasing cost. The first is shortrun decreasing cost. This reflects the fact that once an investment in facilities is made, output can be increased with unit costs declining until the physical capacity of the facilities is reached. run. The second aspect of decreasing cost relates to the long This arises from the relation between unit cost and new capacity previously referred to the fact that at a point in time the unit cost of adding capacity declines as the size of the additional facility increases. Note that whereas the short-run decreasing-cost situation involves fuller utilization of existing capacity, the long-run decreasing-cost |