06 June 2011

How (and why) to raise prices

I hosted a table at GWI's Berlin event to discuss "the politics of raising prices." We had a lot of interested people, and agreed on a number of good ideas for explaining why prices should rise (to cover higher operating, capital or scarcity costs). Among them were:
  • Convince people that "this time is different."
  • Get all stakeholders in the room to reconcile demand and supply, revenue and costs.
  • Advertise so that people understand the changes in demand and supply.
  • Base prices on an objective index (free of political interference) that addresses costs and scarcity
  • Set high prices and rebate excesses (water misers will vote for rebates!)
Got other ideas?

One of the more-interesting stories came from an engineer working in Saudi Arabia. He said that prices in Riyadh were only a few cents per cubic meter for water (a subsidy of over 90 percent). Low prices meant the government had to subsidize the system, but high water demand exceeded supply. Their solution was to supply water for one day in four or five (Jeddah is one day in nine!). This method of "preventing" shortage is harmful for equipment and inconvenient for customers who need to use water tanks during service cuts.

Riyadh is the capital city of nearly 5 million people in a country with a per capita income of $16,000, but it's crippled by this policy.

Bottom Line: Poor water management wastes time, money and water. Better to have fair prices that cover service costs and prevent shortages.

5 comments:

The Pasadena Pundit said...

To state the obvious, generally water is not a market good and markets are mechanisms for finding the lowest price of a good or service.

But as I suspect Dr. Zetland believes, when non-market goods such as water are exposed to markets the Highest and Best Use of water kicks in and can drive up prices above the actual cost to produce potable water.

Sometimes a high price for water is desired in order to increase overall supply. So if desalinated water costs a prohibitive $1,000 per AF and imported treated water costs say $500 AF and local groundwater costs say $100 AF, adding say 5% to 10% of desalinated water to the overall mix may only raise prices marginally while overall supply in increased.

Most markets for water are bilateral monopolies or monopsies of some sort. One buyer and one seller. The entity with the most market power can often control the price thus an asymmetrical pricing structure emerges. The only way to rectify this would be to use an appraiser but this often leads to problems of a hired gun who will conclude what his client wants. Even a neutral appraiser would find it difficult to value given lack of open market water sales transaction where there was no undue influence or captive buyers. But if a neutral appraiser can be found it might be possible to set a fair price for water using assumptions of a simulated open market. The Cost Approach to water pricing would set the floor the issue is what sets the ceiling. Surplus water is often released from gorged dams just as electricity is sometimes sold for less than production cost in the spot market just to get rid of it. Estimated value is always just finding numbers that fit a certain set of assumptions (often not fully undisclosed).

Rich Mills said...

I think people will pay prices when they are convinced the prices are not rigged, as by a monopoly. I pay $2.79 for a loaf of bread, which I consider quite high, because I understand that I have choices and that I am not being jerked around by some bread monopoly.

With regard to water, I think it might be a useful exercise to examine the different parts of the business and see which parts could be opened up to competition that the consumer could understand and participate in. For example, there is no absolute reason why the selling of water must be tied to the business of transporting water. It may be that it would be difficult to have multiple water pipes to your house, but I don't know why people could not buy their own water from different commercial sources which then pay a pipeline company to transport it.

David Zetland said...

@PP -- Interesting point on bilateral monopolies. I can see the monopoly seller side, but monopsonistic buyers are not as common. In your desal example, the price of water "on the margin" should NOT be less than $1,000/af, right? Otherwise (average cost pricing), the water provider is trading $100 bills into $20 bills!

Anonymous said...

Here in Queensland, Australia it was a severe drought that made price rises palatable. The fear of running out of water made people happy to pay more money for less water.

However, its proved to be a double-edge sword. Now that the drought has broken and the dams are full, people expect a price fall. Due to the fixed cost nature of the industry and the scale of the infrastructure response to the drought, prices will continue to rise. This has made life very difficult for politicians. Independent economic regulation, removal of political influence, objectivity, advertising and public education have all proved ineffective at stemming this tide of discontent.

Bob Morris said...

Well, it would be populist (and still dumb) if everyone suffered equally from the shortages. But I’m guessing the Saudi royal family can get as much water as they want anytime they want.

But your main point is quite accurate. Providing ultra-cheap subsidized water to mollify the rabble creates major inefficiencies and shortages. And to do so in a desert is mind-numbingly stupid.