Professor, What do you mean by the term “regulatory dilemma” I refer to the dilemma confronting regulators (e.g., public service commissioners) as they go about the task of subjecting firms covered by their legislative mandate to rate-of- return regulation.

We will use some simple graphs to illustrate that marginal cost pricing will, in the case of sustainable natural monopoly, saddle the regulated firm with losses. The Courts have ruled that the regulated firm must receive a return on shareholder equity that is “fair.”

MWHs $ 0 MR LAC LMC PMPM QMQM QCQC CMCM    Case 1: Unregulated Monopoly D = AR

MWHs $ 0 LAC LMC MR D = AR Case 2: Marginal Cost Pricing   QCQC PCPC C1C1 

Recall the necessary condition for socially efficient resource allocation: P = MC Hence: Option 2 is optimal on social efficiency criteria. Why not select option 2 and subsidize the regulated firm by amount C 1  P C ? Subsidies give rise to problems of distributional equity. For example, suppose that gas companies were subsidies from general tax revenues—does this not amount to an income transfer to gas customers from tax payers that are all electric”?

MWHs $ 0 LAC LMC MR QAQA PAPA   Option 3: Average Cost Pricing

Option PriceQuantity Dead Weight Loss given by area Econ Profit given by area 1PMPM QMQM  P M  C M 2PCPC QCQC 0 (C 1  P C ) 3PAPA QAQA  0 Comparing the results

In summary, option 2 is superior on social welfare grounds—but fails to produce a fair return for the regulated firm. Option 1 certainly gives the regulated firm a hefty return, but fails badly on welfare grounds. Option 3 is a “compromise” and is best in terms of reconciling two objectives—i.e. maximization of the total surplus and the necessity to provide regulated firm a fair return