Politically Feasible, Revenue Sufficient, and Economically Efficient Municipal Water Rates

Water rates are designed to meet multiple objectives, typically resulting in tradeoffs among the objectives of economic efficiency, revenue sufficiency, and related revenue stability. Standard theory of natural monopoly is extended here to explain why long-run marginal cost (LMC) can be greater than both average cost and short-run marginal cost (SMC) for municipal water utilities. The distinctions between ‘‘benign monopoly rates’’ and ‘‘marginal cost rate design’’ favor LMC over SMC as the basis for economically efficient rate design. Taking into account conservation investments by consumers, SMC rates are economically inefficient, except during temporary shortages. The City of Los Angeles adopted economically efficient, revenue sufficient, and revenue-stable water rates at the end of a prolonged drought. After the drought ended, Los Angeles (LA) modified the rate design, making the design politically feasible during normal rainfall years. Unique features in the LA rate design determine the allocation of consumer surplus among ratepayers, making the rate design politically feasible by sharing efficiency gains among customer classes. Revenue sufficiency and stability features in the rate design minimize adverse job effects on water utility management, reducing the frequency of rate hearings with an increasing block design. (JEL L51, L95, Q25, Q51)