THEORY OF PRICING

Meenu Mishra
• Price denotes the exchange value of a good or
service, expressed in terms of money.
• Price of a product or service depends upon a
number of factors. For instance, it could vary
depending on the make of a product (e.g.
different prices for different makes of Maruti car),
or over the types of buyers (, say, wholesalers
and retailers). Price of a product or service could
also vary from place to place because of
transportation cost. Prices could vary depending
on whether a product is purchased in cash or on
credit.
Price Price

Supply

Equilibrium

Demand

Quantity
• Depend on a number of factors – like
consumer’s income, consumer’s taste and
preference, prices of related goods, own
price, structure of market etc. The factors
that influence demand and supply thus
also influence price. A change in demand
and supply generally brings about change
in price
 S1

S2
P1

P2

D1

O Q1 Q2
• Also supply remaining constant,
-increase in demand leads to increase in
price, and
-decrease in demand leads to fall in price.
 S1

P2

P D2
1
D1

O Q2
• Market structures could be of the following
types:
• Pure competition
• Monopoly
• Monopolistic competition and
• Oligopolistic competition
 Pricing under pure competition
• A purely competitive market is
characterized by a large number of buyers
and sellers, non-heterogeneous product,
and easy entry and exit. As the number of
buyers and sellers are large, no individual
buyer or seller can influence market price.
• In the short-run in a purely competitive
market it is possible for a firm to make
above normal profits while at the same
time a firm could exist even when it is
losing in absolute terms (total cost terms).
This, however, is not true in the ‘long-run’.
 Pricing under pure monopoly
• Monopoly market is characterized by
single seller, no close substitute of product
and difficult entry for new entrants. The
above understanding of price
determination under pure competition
would help you appreciate the price
determination under monopoly
• Key conditions that give rise to
monopolies are economies of scales and
barriers to entry. Electricity generation,
gas supply etc. are some examples
representing economies of scale.
Price, cost
per unit
(Rs.)

A Consumer surplus :
monopoly

B
Deadweight loss
P
m Income
Transfer

C
D MC=AC
Pc C

Quantity
Qm Qc D per
period
MR
• If we assume a perfectly competitive industry,
we know that price would be Pc and quantity
Supplied Qc. The consumer’s surplus will be the
area PcAD. Now consider output and price of
the profit maximizing monopolist. As indicated
in the figure, price would be Pm and quantity
would be Qm. Notice that the monopolist will
charge a higher price and produce a lower
quantity as expected. The consumer surplus is
reduced to PmAB. The rectangle Pc Pm BC that
was part of consumer surplus under competition
is now economic profit for the monopolist .
 TYPES OF PRICING
• There are products and services whose demand varies
according to time. There are time periods when demand
increases substantially and supply cannot meet the
demand. Often pricing strategies are adopted to flatten
this curve.
• Peak load pricing is one such strategy. Under this type
of pricing, higher tariff is charged during peak demand
and lower tariff is charged during off-peak period. This
often helps shift demand. Reduced tariff for telephone
(STD/ISD) calls during night is an example of such pricing
strategy. In electricity sector also we have examples of
Time of Day (TOD) tariff, especially for HT consumers
widely prevalent in many States.
• Some Concerns:
• The cost of supply at high voltage is
different from a low voltage. The high and
low load factor affects the cost of ss.
• The cost of ss vary from different
geneartions,regions,government policies.
The generation cost of thermal plants is
about 175 paise a KWh and of remote
units is in the range of Rs2.20-3.40 a Kwh.
 Bundling
• , “Buy one, get the second at half-price”.
A hotel room often comes with
complementary breakfast. These are
examples of Bundling. Bundling is the
practice of selling two or more separate
products together for a single price i.e.
bundling takes place when goods or
services which could be sold separately
are sold as a package. Bundling could be
:
• Pure bundling: (when products are sold
only as bundles);
• Mixed-bundling: (when products are sold
both separately and as a bundle); and
• Tying: the purchase of the main product
(tying product) requires the purchase of
another product (tied product) which is
generally an additional complementary
product
 Two-part tariffs
• Buyers paying a fee for the right to
purchase their product and then to pay a
regular price per unit of the product. For
example, your cable TV company charges
you a base fee for hooking into its system
and then charges you extra for pay by
view transmission. Similarly, many local
telephone companies charge a monthly
base fee and then charge additional fee
based on messages per unit.
• The fee for privilege of service plus prices
for services consumed is called a two-part
tariff. This is a widely used tariff strategy
followed in electricity sector. Tariff has the
components of fixed charge and variable
charge
 REGULATION OF TARIFF –
VARIOUS TYPES
• why regulation of tariff or price is essential,
especially under monopoly. There are a variety
of methods for tariff regulation. The choice of the
method will be dictated by factors like
effectiveness of the method in achieving tariff
objectives, appropriateness, in the light of the
existing methods being used for the purpose
and administrative convenience given the
existing infrastructure and information systems.
The following are the most common forms of
tariff regulation.
• Rate of Return/Cost of Service;
• Marginal Cost based Price;
• Performance Based Regulation (PBR);
• RPI-X;
• Competitive Bidding;
Rate of Return Regulation (RoR)/
Cost of Service
• The rate of return approach requires the
determination of allowable costs, a rate base
and the rate of return to be allowed on the rate
base. The rate base is the capital amount on
which a return is allowed. Typically the rate base
represents the historic cost of the assets
employed, less the accumulated depreciation of
the asset. The data requirements for carrying
out RoR regulation are the historic costs of
investments (in the Indian system the gross
block) together with the variable costs incurred
in the test year.
• This form of regulation has a number of distinct
advantages:
• a) It provides predictable, steady returns for the utility,
which is conducive to making further investments.
• b) The method is conceptually simple and
unambiguous, generally making use of historic
accounting data.
• c) It is perceived to be fair. The cost of the electricity
service is related directly to the actual asset base, with
the end user paying for the facilities used. Today's user
pays for the system built to date.
• d) It is a traditional approach, used over many years,
and is familiar to electric utilities, users and regulatory
agencies.
• The strengths of this form of regulation like its simplicity and
predictability, also create its limitations.
• a) Once an investment is made it tends to remain in the rate base
and earns a return, even if the investment becomes non productive
due to future developments, resulting in "stranded costs".
• b) Since the rate of return and the rate base are the two main
variables in the determination of the return to the utility, there is a
tendency to over invest. Higher the investment, higher the rate base
and hence the return to the investor.
• c) The process is backward looking. The end user pays the
historic cost and there are no price signals regarding future costs.
This is not conducive to the efficient use of energy.
3 Performance Based Regulation
(PBR)
• Recent trends have been towards more
"light handed" regulation i.e. least
interference by the regulators. PBR moves
away from the RoR method by providing
incentives for the utility to improve
efficiency and reduce costs. Rather than
prescribe a return, the utility is given a set
of performance criteria to follow.
• Performance criteria may include both
operational and financial criteria. The
return to the utility depends upon
performance. Over achievement of the
performance criteria can increase returns
for the utility while underachievement will
decrease returns. Performance targets are
set using historic data, trends of system
costs and operational characteristics
• A form of PBR is in actual use in India,
where tariffs are based on normative
parameters. Performance criteria might
include such items as, number of hours of
system degradation (down time), losses
expressed as a % of energy produced,
expenditure on O&M, number of
employees per 1000 consumers, lost time
due to accidents, etc.
• Hybrid and sliding scale methods in PBR
:The hybrid method of PBR combines some of
the best features of
ROR and PBR. The hybrid approach combines
elements of both the methods to suit local
conditions. For some elements of tariff,
performance bench marking could be applied,
whereas with respect to other elements, the
historic cost and rate of return may be applied.
This would be effectively a refinement of the
existing norm based ROR system
 Price Cap Regulation
• It imposes a price cap which, over the
tariff period, can be crossed only to the
extent of the retail price inflation (RPI).
This inflation rate is not fully available as
an add-on to the price cap for the utility. It
is reduced by a pre-determined efficiency
gain (X). The strength of the scheme
derives from the flexibility it affords to the
• utility to incur costs and take actions as is
commercially feasible so long as the
objectives of good quality supply are met
within the capped price. The problem is
how to retain this simplicity in design,
while at the same time ensuring that an
appropriate price (sufficient for financial
viability without being generous), is
allowed, for generating stations of different
fuel types, ages, technology and siting.
• How should the price cap be determined?
Determination of the base year price can
be complex since the regulator must
decide to what extent current inefficiencies
should be allowed. However the decision
is no different than that required under a
PBR regime while setting performance
criteria.
• Which indices are to be used for inflation?
In India, there are the wholesale price
index (WPI), the consumer price indices
(CPI) for agricultural labour, and the CPI
for industrial workers. The latter has
historically been higher than the former.
Which of these is appropriate?
• Determination of the X factor, the proxy for
efficiency improvements, is similarly
complex. Time series data for the actual
costs and efficiencies of a range of
stations and transmission lines would be
required to devise the X factor. Decisions
would also be required on the sharing of
efficiency
• gains between the utility and consumers.
 TARIFF DETERMINATION
THROUGH COMPETITIVE
BIDDING
• This is an alternative to tariff
determination. This is a market based
approach and hence avoids scrutiny of
costs, revenues, etc. which is necessary in
other methods of tariff determination.
Successful adoption of this method
presupposes the existence of competitive
forces at the bidding stage.
 MARGINAL COST BASED
PRICING METHODS
• From a theoretical perspective, marginal cost
pricing methods provide the most appropriate
signals for the pricing of electricity. Marginal
pricing sends out a clear signal to the supplier
and end user regarding the true value of the
power being consumed. Marginal cost pricing
emphasises future economic signals rather than
relying on financial signals based on today's
performance and historic financial costs.
 HISTORICAL PERSPECTIVE OF
TARIFF REGULATION
• Indian Electricity Act, 1910
• Electricity (Supply) Act, 1948
• Electricity Regulatory Commissions
Act, 1998
• Tariff determination under the
Electricity Act, 2003
• :“Section 61. (Tariff regulations):
• Section 62. (Determination of tariff):
• “Section 63. (Determination of tariff by
bidding process):
• “Section 64. (Procedure for tariff
order):

• “Section 65. (Provision of subsidy by

State Government):
• “Section 66. (Development of market):
 GENERAL APPROACH TO
TARIFF
• Introducing competition in different
segments of the electricity industry is one
of the key features of the Electricity Act,
2003.
• Tariff policy lays down following
framework for performance based cost of
service regulation in respect of aspects
common to generation, transmission as
well as distribution. These shall not apply
to competitively bid projects as referred to
in para 6.1 and para 7.1 (6). Sector
specific aspects are dealt with in
subsequent sections
• Return on Investment
• Equity Norms
• Depreciation
• Cost of Debt
• Cost of Management of Foreign
Exchange Risk