What to do About the Local Water Monopoly?

This activity is appropriate for an introductory microeconomics course. Students should be acquainted with the methods and vocabulary of economic reasoning. They should be familiar with the monopoly graph but it is better if they have not read textbook sections on regulations, as the activity is designed for them to grapple with the pluses and minuses of each approach themselves.

Overview

In this activity, students are confronted with a local water monopoly. Students debate what, if any, regulations their municipality should put on the monopoly to ensure the most optimal outcome. Do they leave it alone, mandate some price and quantity, impose cost-plus regulations, or institute a price cap?

Expected Student Learning Outcomes

Students will grapple with different approaches to regulating a monopoly. They will be able to think about the problem in economic terms while taking stakeholders into account.

Information Given to Students

Your group is the city council of a small town. The water company in your town, Water Corp., is an unregulated natural monopoly. Some residents have complained about high prices and service issues associated with Water Corp. As the city council, what course of action do you recommend to ensure the most optimal outcome for all involved? What are the benefits and downsides of each approach?

A.) Leave Water Corp. unregulated and let the market decide.

B.) Mandate what price Water Corp. charges and the quantity they must deliver.

C.) Institute cost-plus pricing. This means a normal rate of profit will be added to Water Corp's costs to determine the price customers pay.

D.) Enact a price cap – tell Water Corp. they cannot charge more than a certain amount.

In prefatory remarks, the instructor should draw a standard monopoly price and quantity graph. This will aid students in their reasoning out of pluses and minuses of each approach to regulation. The instructor could remind students that the profit maximizing condition is MR = MC.

In giving their answers, the instructor should remind students to specify how their choice affects each party involved. Their choice should not simply be "best" but "best for who" and why.

Explanation of Choices

A.) Leave Water Corp. unregulated and let the market decide.

This will likely be an unpopular solution. An ardent group of students of the neoclassical persuasion could potentially make a logically cogent case for it if they backed up their argument with theory. Our standard textbook theory predicts that leaving the monopoly alone will result in restricted quantities supplied which induce prices higher than equilibrium.

B.) Mandate what price Water Corp. charges and the quantity they must deliver.

This will also likely be an unpopular solution. Groups making this choice will have an uphill battle making an argument for this type of planning. It will have to come from outside the standard econ 101 textbook. The standard theory predicts that mandating a lower price will result in a shortage of water supplied.

C.) Institute cost-plus pricing. This means a normal rate of profit will be added to Water Corp's costs to determine the price customers pay.

This is likely to be a popular choice as it is discussed at length in most introductory texts. The benefits are that companies will make a base-line amount of profit so they will be incentivized to produce. The downside is that there could be an active or passive incentive to let costs increase, lowering efficiency. Corruption and inefficiency could follow unless firms are monitored closely.

D.) Enact a price ceiling – tell Water Corp. they cannot charge more than a certain amount.

This will also likely be a popular choice. Setting a price ceiling incentivizes companies to be efficient and reduce costs. Their profit margins depend on their ability to find efficiencies, as raising their price to increase their margin is not an option. The downside is that if the price is too low, firms may not make enough money in the long term to justify producing adequate amounts of their goods and services.

Potential Issues

Water is an essential good. There are deep moral issues involved with discussions of who should have access to necessary goods. Moral issues are relevant, but it is also important to ensure groups are thinking about the issue economically, using reasoning learned within the course.

Actual water regulation varies substantially between different regions and communities in the US. In general, water utilities throughout the country have followed the trend of privatization that began in the 1970's and 80's. Proponents argue privatization increases efficiency and consumer welfare. Some studies have found, however, higher degrees of private ownership translate to higher prices and worse service. Because water is essential to life, deciding how this resource is managed is of utmost importance.

Further resources and discussion are included in the "additional resources" section.

A potential take-home essay question could be to try to find a real example of how a monopoly was regulated in the United States or abroad. What happened? Did regulators change their approach over time? What parties were affected and was everyone happy with the results?

Overview of regulating natural monopolies, including Price Cap vs Cost Plus regulation:
https://en.wikibooks.org/wiki/Principles_of_Microeconomics/Regulating_Natural_Monopolies

Information on how water companies are actually regulated in the US:
https://www.sciencedirect.com/science/article/abs/pii/S0957178712000501

World Bank paper on water regulation:
https://elibrary.worldbank.org/doi/abs/10.1596/1813-9450-1649

Study on public vs. privately owned water utilities:
https://iwaponline.com/wp/article/24/3/500/87702/Water-pricing-and-affordability-in-the-US-public