IUE e chapter 2: scale and scope economies in the utilities – theory & evidence


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This chapter uses the basic utility concepts explained in Chapter 1. The real evidence for scale economies and scope economies in each of the four stages of electricity, gas, water and wastewater is reviewed in this chapter, which closely examines the theory and modern evidence for the classic fixed costs theory of natural monopolies propounded in most economics textbooks today. The simple theory is first explained, then made rigorous by defining relevant concepts more precisely, and teasing out whether we are considering marginal costs in a cross-sectional or time-series sense. Next, proper definitionsĀ of the short and long run in industries with very long asset lives and huge irreversible sunk costs are considered; we note that some utilities have very different governance priorities (efficiency is prized by some but not all utility supervisors). The real cost drivers of pro-active (or preventative) and reactive maintenance in each utility industry are carefully explained. Finally, the hard statistical evidence for scale economies and scope economies in the modern utility industries is examined; it is found to be rather weak at the scale of modern utilities, and some strong counter-examples are shown where modern managements have asked to split up large national utilities because of diseconomies of scale. Finally the paradox of telecoms grids which are sometimes monopolies, sometimes duopolies, and sometimes furiously competing oligopolies is considered; this shows up the weaknesses inherent in neoclassical assumptions of an equilibrium market structure, when many of today’s industry have no such equilibrium in sight.

The paradoxes are resolved by introducing time and technology into the model, adopting the concept of sunk costs as an asymmetry in time and technology, and using the general sequential model explained in Chapters 3 and 4. The true Long Run Marginal Cost of water in a forward-looking time-series sense – the Long Run Incremental Cost – is derived and drawn as a diagram in Chapter 5 – it looks nothing like the LRMC of water assumed by most academic economists.

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