Friday, February 25, 2005

Water matter with this story? 

Time to be nicer to Chad, since he shared with me a letter asking for an explanation of the water-pricing policies of the Denver water public utility. This is going to end up being used as a case study for one of my principles classes, I think.
The drought-savvy ways of Denver Water's customers are pinching the finances of the state's largest water utility, and that could mean an extra rate hike this year.
Chad's correspondent is trying to figure out why the utility would raise rates when people aren't using enough water; thinking about demand would mean Denver Water should decrease price, right? Maybe, maybe not. Since water is in essence a zero marginal cost item -- it costs practically nothing to pump one more gallon to a household -- the job of Denver Water, if it was a profit maximizer, would be to maximize total revenue; that more or less water is used is irrelevant, as long as it doesn't run out. It would do so by raising price if the demand for water was relatively inelastic -- that is, if the responsiveness of consumers to increasing prices wasn't too high.

The utility had forecast 2005 water sales of $169.5 million, about 11 percent below normal. But even before the summer watering season hits, customers are reducing use, causing utility officials to prepare for reductions of as much as 20 percent to 30 percent, and water sales of just $144.8 million...
If it was just a reaction to the 8% increase in price Denver Water imposed on Jan. 1, that would not be inelastic at all. The problem is that the drought has led DW to engage in a conservation program which, if successful, shifts demand. And it appears they were quite successful. So the elasticity point, and the raising price to increase quantity demanded point, are out the window.

What happened? The key is here:
Denver, directed by city charter to keep its water rates low, has tried to keep a lid on water price hikes.
DW is a regulated utility, told to keep prices low and not maximize profits. They also are allowed to raise prices to cover their costs. So if the conservation is successful, you have less water being sold to cover the same amount of expenses as they had before. Thus prices have to rise in response to balance DW's budget. (Principles students: you are setting price equal to average cost with the regulated monopolist, and if you're on the downward sloping portion of the AC curve, this is the result.)