Technical University of Munich

TUM School of Life Sciences Weihenstephan

Production and Resource Economics

WI001204: Economics of Water Use, Regulation and Markets

“In-class” activity #3
28.05.2020

Welfare Change from AC Pricing to Two-Part Pricing

We wanted to show how to graphically represent the change in welfare in moving from Average
Cost Pricing to Two-Part Pricing.

The first graph we worked with depicts the net changes to social welfare, which was a result of
changes faced by both the consumer in welfare and the utility in costs. Once we add up all these
changes, we found that the two remaining areas were A and B in the figure below. And, we conclud
that:

∆𝑊 = 𝐴 − 𝐵 (1)

Net change in Welfare from comparing Average-Cost Pricing to Two-Part Pricing equals to A-B

O*
* O**
r’
O

M’
Welfare from Average-Cost Pricing: [MM’O*r*]
Welfare from Two-part Pricing: [MM’O**r’]

Net change in Welfare from comparing Average-Cost Pricing to Two-Part Pricing

=[MM’O*r*]-[MM’O**r’]
=[r’r*O*O]-[M’OO**]
=A-b

The figure below depicts the same model, but with various areas relabeled. In particular, area A
in the above graph is drawn as area C + L in the graph below. And, area B above is labeled as
area H below.

A−B (Graph above) = G+L (from Graph below) (2)

r**
To prove Equation (2), we first consider how fixed cost is represented graphically for each
equilibrium state:

• For AC pricing, fixed cost is represented by C + F

• For Two-part pricing, fixed cost is represented by F + G + H

Because fixed cost is the same for each scenario, by definition, then these areas are equal:

C+F=F+G+H ⇒ C=G+H (3)

Now, we return to Equation (1):

∆W = A − B

Since we can see that A = C + L and B = H, we have:

∆W = C + L − H (4)

We observed above, in Equation (3), that C = G + H, so we will substitute into Equation (4):

∆W = C + L − H = G + H + L − H (5)

Thus, we have our desired result:

∆W = G + L (6)

To conclude, we write an expression for this simpler geometry, which represents the change in
welfare of moving from Average Cost Pricing to Two-Part Pricing as:
)
∆𝑊 = * (r*-r**)(q**-q*) (7)

∆𝑊 = 0.5(12-5)(12-8.75)

∆𝑊 = 11.375