IUE e chapter 5: calculating Long Run Incremental Costs (LRICs) for a network utility


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Chapter 5 shows how to calculate a Long Run Incremental Cost (LRIC), which is a forward-looking long run marginal cost for a network utility in a time-series sense, rather than a cross-sectional sense.

Building on the sequential theory of Chapters 3 and 4, Chapter 5 starts by explaining the nature of the problem for utilities needing to expand their infrastructure against a typical background of assumed rising demand caused by population growth, or rising real incomes. Any permanent new customer will put an additional permanent load on the system, which will bring forward a utility’s entire investment program. In 1968 Ralph Turvey developed a method for calculating the Long Run Incremental Cost of the new customer’s load, which amounts to a forward-looking Long Run Marginal Cost (LRMC) in a time-series sense. The chapter explains the general theory and then takes the reader through a detailed example for the case of a modern water company which abstracts, treats, stores and distributes clean water across a significant area drawing on the author’s experience working with over thirty utilities around the world, including the limitations of utilities’ real processes and IT systems. The resulting diagram of forward-looking LRMCs would astound most academic economists, though not seasoned utility economists who have seen this kind of result – a discontinuous rising LRMC for the industry which most economic textbooks hold up as the strongest natural monopoly of all – many times before. It is worth adding that the chapter draws on the author’s experience calculating these kinds of costs for many real water companies, and that the example types of costs are the main cost-drivers for modern utilities – not least the cost of migrating good quality data from old IT systems to new ones, which occurs in most modern utilities at least once a decade.

The chapter segues naturally into Chapter 6, which explains the types of output delivered at each stage of a utility value chain, and Chapter 7, which examines the main ways to measure the efficiency of natural monopoly utilities. The outcome of this chapter is of course seminal for Chapters 8 and 11.

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