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THEORY OF PRICING Meenu Mishra

• Price denotes the exchange value of a good or service, expressed in terms of money. • Price of a product or service depends upon a number of factors. For instance, it could vary depending on the make of a product (e.g. different prices for different makes of Maruti car), or over the types of buyers (, say, wholesalers and retailers). Price of a product or service could also vary from place to place because of transportation cost. Prices could vary depending on whether a product is purchased in cash or on credit.

Price

Price Supply Equilibrium

Demand

Quantity

• Depend on a number of factors – like consumer’s income, consumer’s taste and preference, prices of related goods, own price, structure of market etc. The factors that influence demand and supply thus also influence price. A change in demand and supply generally brings about change in price

S1

S2

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P2

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• Also supply remaining constant, -increase in demand leads to increase in price, and -decrease in demand leads to fall in price.

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• Market structures could be of the following types: • Pure competition • Monopoly • Monopolistic competition and • Oligopolistic competition

Pricing under pure competition • A purely competitive market is characterized by a large number of buyers and sellers, non-heterogeneous product, and easy entry and exit. As the number of buyers and sellers are large, no individual buyer or seller can influence market price.

• In the short-run in a purely competitive market it is possible for a firm to make above normal profits while at the same time a firm could exist even when it is losing in absolute terms (total cost terms). This, however, is not true in the ‘long-run’.

Pricing under pure monopoly • Monopoly market is characterized by single seller, no close substitute of product and difficult entry for new entrants. The above understanding of price determination under pure competition would help you appreciate the price determination under monopoly

• Key conditions that give rise to monopolies are economies of scales and barriers to entry. Electricity generation, gas supply etc. are some examples representing economies of scale.

Price, cost per unit (Rs.) Consumer surplus : monopoly

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B P m

Deadweight loss

Income Transfer C

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MC=AC

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Quantity per period

• If we assume a perfectly competitive industry, we know that price would be Pc and quantity Supplied Qc. The consumer’s surplus will be the area PcAD. Now consider output and price of the profit maximizing monopolist. As indicated in the figure, price would be Pm and quantity would be Qm. Notice that the monopolist will charge a higher price and produce a lower quantity as expected. The consumer surplus is reduced to PmAB. The rectangle Pc Pm BC that was part of consumer surplus under competition is now economic profit for the monopolist .

TYPES OF PRICING • There are products and services whose demand varies according to time. There are time periods when demand increases substantially and supply cannot meet the demand. Often pricing strategies are adopted to flatten this curve. • Peak load pricing is one such strategy. Under this type of pricing, higher tariff is charged during peak demand and lower tariff is charged during off-peak period. This often helps shift demand. Reduced tariff for telephone (STD/ISD) calls during night is an example of such pricing strategy. In electricity sector also we have examples of Time of Day (TOD) tariff, especially for HT consumers widely prevalent in many States.

• Some Concerns: • The cost of supply at high voltage is different from a low voltage. The high and low load factor affects the cost of ss. • The cost of ss vary from different geneartions,regions,government policies. The generation cost of thermal plants is about 175 paise a KWh and of remote units is in the range of Rs2.20-3.40 a Kwh.

Bundling • , “Buy one, get the second at half-price”. A hotel room often comes with complementary breakfast. These are examples of Bundling. Bundling is the practice of selling two or more separate products together for a single price i.e. bundling takes place when goods or services which could be sold separately are sold as a package. Bundling could be :

• Pure bundling: (when products are sold only as bundles); • Mixed-bundling: (when products are sold both separately and as a bundle); and • Tying: the purchase of the main product (tying product) requires the purchase of another product (tied product) which is generally an additional complementary product

Two-part tariffs • Buyers paying a fee for the right to purchase their product and then to pay a regular price per unit of the product. For example, your cable TV company charges you a base fee for hooking into its system and then charges you extra for pay by view transmission. Similarly, many local telephone companies charge a monthly base fee and then charge additional fee based on messages per unit.

• The fee for privilege of service plus prices for services consumed is called a two-part tariff. This is a widely used tariff strategy followed in electricity sector. Tariff has the components of fixed charge and variable charge

REGULATION OF TARIFF – VARIOUS TYPES • why regulation of tariff or price is essential, especially under monopoly. There are a variety of methods for tariff regulation. The choice of the method will be dictated by factors like effectiveness of the method in achieving tariff objectives, appropriateness, in the light of the existing methods being used for the purpose and administrative convenience given the existing infrastructure and information systems. The following are the most common forms of tariff regulation.

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Rate of Return/Cost of Service; Marginal Cost based Price; Performance Based Regulation (PBR); RPI-X; Competitive Bidding;

Rate of Return Regulation (RoR)/ Cost of Service • The rate of return approach requires the determination of allowable costs, a rate base and the rate of return to be allowed on the rate base. The rate base is the capital amount on which a return is allowed. Typically the rate base represents the historic cost of the assets employed, less the accumulated depreciation of the asset. The data requirements for carrying out RoR regulation are the historic costs of investments (in the Indian system the gross block) together with the variable costs incurred in the test year.

• This form of regulation has a number of distinct advantages: • a) It provides predictable, steady returns for the utility, which is conducive to making further investments. • b) The method is conceptually simple and unambiguous, generally making use of historic accounting data. • c) It is perceived to be fair. The cost of the electricity service is related directly to the actual asset base, with the end user paying for the facilities used. Today's user pays for the system built to date. • d) It is a traditional approach, used over many years, and is familiar to electric utilities, users and regulatory agencies.

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The strengths of this form of regulation like its simplicity and predictability, also create its limitations. a) Once an investment is made it tends to remain in the rate base and earns a return, even if the investment becomes non productive due to future developments, resulting in "stranded costs". b) Since the rate of return and the rate base are the two main variables in the determination of the return to the utility, there is a tendency to over invest. Higher the investment, higher the rate base and hence the return to the investor. c) The process is backward looking. The end user pays the historic cost and there are no price signals regarding future costs. This is not conducive to the efficient use of energy.

3 Performance Based Regulation (PBR) • Recent trends have been towards more "light handed" regulation i.e. least interference by the regulators. PBR moves away from the RoR method by providing incentives for the utility to improve efficiency and reduce costs. Rather than prescribe a return, the utility is given a set of performance criteria to follow.

• Performance criteria may include both operational and financial criteria. The return to the utility depends upon performance. Over achievement of the performance criteria can increase returns for the utility while underachievement will decrease returns. Performance targets are set using historic data, trends of system costs and operational characteristics

• A form of PBR is in actual use in India, where tariffs are based on normative parameters. Performance criteria might include such items as, number of hours of system degradation (down time), losses expressed as a % of energy produced, expenditure on O&M, number of employees per 1000 consumers, lost time due to accidents, etc.

• Hybrid and sliding scale methods in PBR :The hybrid method of PBR combines some of the best features of ROR and PBR. The hybrid approach combines elements of both the methods to suit local conditions. For some elements of tariff, performance bench marking could be applied, whereas with respect to other elements, the historic cost and rate of return may be applied. This would be effectively a refinement of the existing norm based ROR system

Price Cap Regulation • It imposes a price cap which, over the tariff period, can be crossed only to the extent of the retail price inflation (RPI). This inflation rate is not fully available as an add-on to the price cap for the utility. It is reduced by a pre-determined efficiency gain (X). The strength of the scheme derives from the flexibility it affords to the

• utility to incur costs and take actions as is commercially feasible so long as the objectives of good quality supply are met within the capped price. The problem is how to retain this simplicity in design, while at the same time ensuring that an appropriate price (sufficient for financial viability without being generous), is allowed, for generating stations of different fuel types, ages, technology and siting.

• How should the price cap be determined? Determination of the base year price can be complex since the regulator must decide to what extent current inefficiencies should be allowed. However the decision is no different than that required under a PBR regime while setting performance criteria.

• Which indices are to be used for inflation? In India, there are the wholesale price index (WPI), the consumer price indices (CPI) for agricultural labour, and the CPI for industrial workers. The latter has historically been higher than the former. Which of these is appropriate?

• Determination of the X factor, the proxy for efficiency improvements, is similarly complex. Time series data for the actual costs and efficiencies of a range of stations and transmission lines would be required to devise the X factor. Decisions would also be required on the sharing of efficiency • gains between the utility and consumers.

TARIFF DETERMINATION THROUGH COMPETITIVE BIDDING

• This is an alternative to tariff determination. This is a market based approach and hence avoids scrutiny of costs, revenues, etc. which is necessary in other methods of tariff determination. Successful adoption of this method presupposes the existence of competitive forces at the bidding stage.

MARGINAL COST BASED PRICING METHODS • From a theoretical perspective, marginal cost pricing methods provide the most appropriate signals for the pricing of electricity. Marginal pricing sends out a clear signal to the supplier and end user regarding the true value of the power being consumed. Marginal cost pricing emphasises future economic signals rather than relying on financial signals based on today's performance and historic financial costs.

HISTORICAL PERSPECTIVE OF TARIFF REGULATION • • • • •

Indian Electricity Act, 1910 Electricity (Supply) Act, 1948 Electricity Regulatory Commissions Act, 1998 Tariff determination under the Electricity Act, 2003 :“Section 61. (Tariff regulations):

• Section 62. (Determination of tariff): • “Section 63. (Determination of tariff by bidding process): • “Section 64. (Procedure for tariff order): • “Section 65. (Provision of subsidy by State Government): • “Section 66. (Development of market):

GENERAL APPROACH TO TARIFF • Introducing competition in different segments of the electricity industry is one of the key features of the Electricity Act, 2003.

• Tariff policy lays down following framework for performance based cost of service regulation in respect of aspects common to generation, transmission as well as distribution. These shall not apply to competitively bid projects as referred to in para 6.1 and para 7.1 (6). Sector specific aspects are dealt with in subsequent sections

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Return on Investment Equity Norms Depreciation Cost of Debt Cost of Management of Foreign Exchange Risk