-65 situation applies to the economies associated with larger rather than smaller additions to capacity. The third aspect of decreasing cost reflects technological progress. Note that the second aspect is essentially static: at any point in time, with given technology, larger capacity increments tend to be associated with lower unit costs. But this third aspect of decreasing cost is dynamic: as technology changes, the unit costs of adding capacity decline. Since technological progress is stimulated by an expanding market, the latter aspects often go hand in hand. All three aspects of decreasing cost have one characteristic in common: the more rapidly the utility expands to meet growth in its markets, the lower will be its unit cost of providing service. And this declining unit cost means that, barring rapid inflation, the complete incremental cost of adding customers or services at any time will be 34/ below the average historic cost of providing that service. And even if rapid inflation should occur, the incremental cost will at least be lower than it otherwise would be with slower growth. Economic theory tells us that the optimum allocation of resources will result from a situation in which each customer is charged 34/ This will not be so if the decline in the historic rate base -66 the marginal cost of serving him; economic reality requires that the utility, on an overall basis, recover all its costs and a reasonable return on its historic net investment. Since adherence to the first precludes achievement of the second in the presence of decreasing costs, some economically appropriate resolution of the conflict is necessary. This resolution is possible by designing rates which reflect, even in very rough fashion, the differing demand elasticities of the various This is the essence of appropriate price differentiation, which can be distinguished from "undue discrimination" by examining the danger ascribed to the latter. service-users. The regulatory disinclination to permit rate differentials appears to have been based on what Federal Power Commissioner Ross has disapprovingly termed "the simple rule that two different prices for the same unit is discrimination, and therefore unlawful....' ... 35/ The regulators explicitly or implicitly feared the possibility that a utility would be inclined to cut rates to certain customers even though their demands were so inelastic that revenues would not increase as much as would the cost of providing the additional quantities of service demanded at the lower price. The regulators' concern was based on the possibility that, unable to recover a reasonable return on the added 35/ Address by Charles R. Ross before the Legal Seminar of -67 investment from the customers responsible for it, the utility would attempt to recoup from other customer groups. Thus, the regulatory agency must, properly, be alert to the possibility that utility managements may take on business at less than incremental cost, to the detriment of other customer groups. But this conception of undue discrimination contains the > basis for defining that discrimination which is desirable. At the risk of repetition, we would like to emphasize again that if the utility can take on business, which it might not otherwise get, at rates which cover complete incremental cost, it will benefit its other customers by taking on that business. Even if the new business covers only its incremental cost, existing users cannot possibly be burdened (and may well be benefited by accelerated growth); if it covers even slightly more than that, it will be contributing to the coverage of the fixed costs which previously were borne in their entirety by then-existing customers. Furthermore, if the additional business makes possible construction of facilities which are larger than they would otherwise additionally benefited. This is the "growth cycle" to which we have already referred. -68 Finally, the additional business accelerates the rate of technologically induced cost reduction by speeding up the phasing-in of new, more efficient equipment. These cost characteristics, then, provide a rationale for encouraging such price discrimination as meets the complete-incremental cost standard. D. Summary of Economic Rationale The approach to ratemaking appropriate to the abovedescribed circumstances may be briefly summarized as follows. If the demand for a utility's service is relatively responsive to price, the justification of the rate should be made in terms of a comparison of the long-run incremental costs and long-run incremental revenues attributable to that service, the optimum rate being that which maximizes longThe assumption which thus underlies any competitive rate is that the volume of sales will so respond to that rate run incremental net revenue. as to justify it. An appropriate rate should, at a minimum, be in excess of the complete incremental cost involved in providing the service. If the rate is in excess of that cost, then other customers will benefit from the expansion of this service since the company's overall cost of service will be increased less than its revenues. But the lower limit of such a com the complete incremental cost of providing the service. -69 is not necessarily the economically appropriate level at which to set that rate (although it will not harm existing customers). Rather, at that point or at some point above it, there is a rate level which will maximize the incremental net revenues from that service and which is therefore the best rate from the economic point of view. At that rate this new business will be making its maximum contribution toward overheads. The precise rate satisfying this condition will depend on just how sensitive demand is to price: the more sensitive, or elastic, demand is with respect to price, the lower will be the optimum rate. Even if there were an agreed-upon allocation method for measuring the cost responsibility of each class of business, and rates were set on that basis to provide the same rate of return on each class 361 of business, they would not necessarily be the most economic rates. If there were any class (or classes) of customer (e. g., Class I) whose demand were sufficiently responsive to price and if the complete incremental cost of expanding the service to the Class I customer were lower than its fully-allocated cost, then the economically optimum rate - fined earlier as the rate which maximizes incremental net revenues de would be lower than fully-allocated costs. In such a case, the rate paid 361 The obvious assumption here is that it is possible, for our purposes, to reach some useful conclusions concerning cost allocation methods. |