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MANAGERIAL ECONOMICS
NOTES ON PUBLIC PRICING
1.
Why User Charges? Allocative Economic Efficiency
Given the significant amount of (scarce) resources that governments employ in producing the
goods and services that they provide to society, it is important these resources are employed in an
economically efficient manner.
Economic efficiency means both productive efficiency and allocative efficiency. Efficiency
concerns the way in which scarce resources are allocated among, and employed in, the
production of the various goods and services produced in an economy, including the goods and
services produced by the public sector. Resources are said to be allocated efficiently when it is
not possible to re-allocate resources, producing less of some products and more of others,
without making someone worse off than before. This is also called Pareto optimality. It can be
shown that the economy is allocatively efficient when, for each and every product produced and
distributed, its marginal cost of production equals its price. (See, for example, Lipsey and Ragan,
Microeconomics, 10th Canadian edition, pp. 281 ff.)
If, for example, the price of a product is less than its marginal cost of production, then the value
that consumers of that product place on the consumption of the last unit(s) consumed of the
product is less than the value of the resources employed in the production of the last unit of the
product (and, therefore, given productive efficiency, the value of alternative products that could
be produced using those resources). This is clearly inefficient. Efficiency could be increased by
increasing the price of the product, inducing consumers to consume less of the product, and
reallocating the resources freed up by producing less of this product to the production of other,
more valued, goods and services.
For many (most) government produced goods and services, it is not the case that the price equals
the marginal cost of production. Many have historically been provided at no charge to the
user/consumer. This situation is clearly allocatively inefficient. When the price of a product
produced by government was previously zero and a non-zero price is introduced, this is usually
seen by consumer-taxpayers as the introduction of a user charge on a previously “free” good.
That the product in question was not truly free, since its production and distribution was
previously paid for from tax revenue (or government deficit funding), is often ignored.
Unfortunately, too often user charges are introduced or raised, not as a means of increasing
economic efficiency, but for the purpose of generating additional government revenue (or
reducing costs by deterring consumption of public goods.) The price may then be set either
above or below marginal cost; in either case this is inefficient, although perhaps less so than
when the product was free.
Notes on Public Pricing
© Brian Christie, February 2000, 2001; October 2006
2.
Financing the Production and Delivery of Public Sector Goods and Services
Rather than financing the production and delivery/distribution of public sector products out of
general government revenues (or borrowing), governments can select from a range of options,
choosing one or more (a mix) of the following means:
A. Benefit taxes. Benefit taxes are levied on individuals or organizations that are thought to
benefit as a group from certain government goods or services. These taxes are not,
however, directly related to the amount of consumption of the services by specific
economic units. Examples include property taxes on residences within a school district to
finance public education, whether or not there are school age children in the household.
Another example is gasoline taxes, assumed to be related to road maintenance and
construction costs. (In Canada revenue from gasoline taxes are not earmarked for
expenditures on roadways despite the pleas of automobile consumer groups and the
trucking industry.)
B. Fees or user fees. These are fees levied by governments on individuals or firms or
institutions to recover the cost or part of the cost of a particular government service that is
required by law or regulation. The government will usually be the monopoly provider of
the service and the “user” will usually be required to consume the service and pay the fee
in order to carry out some necessary function. A common example is a license fee of
some sort (marriage license fee, vehicle permit fee, inspection fee, etc.).
C. User charges. Sometimes defined to include user fees and even benefit taxes, more
narrowly user charges are levied on consumers of government goods and services in
proportion to the amount consumed. The amount consumed has some voluntary nature to
it and there may even be competitive providers or substitute products. Examples include
university tuition fees, postage rates and municipal water charges. Factors considered in
setting the level of such charges will likely include costs (perhaps including social costs/
negative externalities), perhaps demand characteristics, willingness/ability to pay, and
social benefits/ positive externalities.
D. Prices. These are applied to the consumption of government goods and services that are
provided essentially as if from the private sector although by government agencies. With
the privatization of many crown corporations there are fewer instances of such prices. On
the other hand, other government agencies, e.g. Statistics Canada, have introduced prices
for their products that apparently are determined as if the agency was a private sector
firm.
3.
Earmarking and User Charges
Earmarking means that government revenues from a particular source are dedicated (earmarked)
to be spent for specific services, e.g. payroll taxes that are earmarked for employment insurance
and job training or for pensions. Usually, there is some connection drawn between the revenue
© Brian Christie, February 2000, 2001; October 2006
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source and the intended use of the resulting revenue. But this is not always the case; originally
some provincial sales taxes were designated “health and education taxes”, presumably because
these are the major expenditure areas of provincial governments. This was not true earmarking.
Economists argue that more use should be made of earmarking revenues but in Canada this is not
the normal practice. Usually in Canada government revenues from particular levies are not
earmarked for specific expenditure purposes. (The exceptions are often user charges or prices
that are retained by the agency that charges them and used for its purposes.) Thus normally
taxation decisions and expenditure decisions are made separately and, not surprisingly, user fees
and charges are often determined independently from the costs of providing the products charged
for. In this environment, if a government undertakes to add or increase the level of a public
service, taxpayers cannot know whether this action will increase taxes (which taxes and who
pays?), or the deficit, or lead to a decrease of some other public service(s) (which ones?).
Conversely, an increase in a user fee may or may not result in an improvement or extension of
services, and may even cause a reduction of service if the quantity demanded falls as a result. In
such circumstances, taxpayer-voters and their representatives cannot make rational economic
decisions about whether to support or oppose government initiatives because they do not know
the costs or benefits of the proposed change.
With earmarking, a proposed increase in revenue from an increased fee or charge will be used to
expand or improve the service or product for which the charge is collected. Taxpayers can know
whether they support the expansion at the cost proposed and decide whether to support the cost
and benefit pairing that results.
Thus the advantages of earmarking include:
A. the efficiency benefits of using user charges that approximate marginal costs,
B. reduced taxpayer resistance to increased taxes/charges because of the identified
benefits,
C. greater accountability for the expenditure of government revenue,
D. an enhancement of democratic decision-making, and
E. improved levels of financing of services desired by taxpayer-consumers.
The disadvantages include:
A. the expense of controlling many separate funds,
B. the risk of inappropriate linkages between revenues and expenditures that are
unrelated to economic efficiency, e.g. when government support of public service
agencies is funded out of lottery proceeds or a levy on casino profits,
C. incentives to cost centre managers of monopoly public services to maximize
revenue rather than operating at economically efficient volumes and charges, and
D. the increased unpredictability of revenues available for various government
activities.
One method of implementing earmarking arrangements is the establishment of “quasi-public/
quasi-private” self-financing (or subsidized) operating agencies such bridge authorities or water
© Brian Christie, February 2000, 2001; October 2006
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commissions. When appropriate these may be a stepping stone to privatization of operations that
can be delivered on a competitive basis.
4. Setting User Charges and Fees
According to economic theory, the efficiency maximizing user fee or charge (“price”) is equal to
the marginal cost of providing the good or service, i.e. the cost attributable to the production and
distribution of the last unit of the product that is produced. This is termed the marginal cost
price. Even in the private sector defining and measuring the marginal cost can be a challenge. In
the public sector this challenge is often greater. Public sector accounting systems are not
designed to attribute costs to “products” and production. The attribution of joint and overhead
costs may not be easy. (Joint costs are costs shared among the production of more than one
product.) Costs can also be lumpy so that measuring marginal costs requires interpolation along
a discontinuous cost curve.
Moreover, there are differences between economic costs and accounting costs that may raise
more difficult conceptual problems for public sector activities. What, for example, is the
opportunity cost of congestion and waiting times on roads, in hospital emergency rooms, or in
the air above airports? What is the best method to value the lost returns from not selling or
leasing the sites of museums, parks or roadways for some alternative use? And at what level of
output should the marginal cost be estimated if introducing a user charge will reduce the quantity
demanded by an unknown amount because there is no good estimate of the price elasticity of
demand? Presumably, experience with the application of user charges/fees will lead to
increasingly better answers to these questions and increased sophistication in estimation
techniques. However, these are important practical issues that require careful consideration in
the setting of the best or most appropriate (efficiency-enhancing) rates of user fees and charges.
Another important consideration is the treatment of fixed costs (e.g. investment costs). These
can be particularly an issue for fees charged to users of major public facilities (e.g. new
highways, bridges, ports, and other utilities). In principle, allocative efficiency requires short-run
marginal cost prices (SRMC) be employed to ensure that such facilities are efficiently used.
This, however, can lead to two possible problems if the government is the sole owner/provider of
such facilities/services.
A. Some public services are best organized as a natural monopoly, an activity in which the
economies of scale are so large that one operation can most efficiently supply the entire demand
for the service, e.g. when only a single controlled access highway is required between point A
and point B. If the short-run cost structure of such a facility is such that all demand can be
satisfied before the minimum average variable cost level of output is reached, then the SRMC
price will fail to recover total variable costs and the operation will incur losses, even before fixed
costs are considered. (See Lipsey and Ragan, p.290, Figure 12-6(i).)
Such deficits must be financed in some manner. One solution is to cover them from general
public revenue. But from an equity point of view, why should the users of the facility/service be
© Brian Christie, February 2000, 2001; October 2006
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subsidized by other taxpayers? (There may be arguments based on externalities such as
economic development effects or pollution abatement or, for a safer highway, reduced public
health care expenditures.) Alternatively, the price could be set at the average cost and all costs
recovered. But, at the higher price, usage will decline and efficiency will be reduced.
B. Even in the unlikely circumstances that SRMC pricing does result in costs being exactly recovered in the short run, it is quite possible that the long run average cost curve of the operation
lies below the short run average cost curve. This means that in the long run the scale of the
operation or size of the facility should be varied (increased) to achieve productive efficiency and
lower costs and prices/charges. (See Lipsey and Ragan, p. 220, Figure 9-9.) But if government
is the sole provider of the service, it may lack the profit motivation that would cause a private
sector firm to expand its scale of operation in the long run and reduce costs. Indeed, government
organizational and investment decisions may place more emphasis on other objectives,
geographic distribution of activities, for example. Thus the university sector in Nova Scotia
contains more institutions than are economically efficient and most cannot capture the full
economies of scale available to larger universities with the same range of programs in other
provinces. The appropriate tool for public sector decision-making regarding the scale of new
public investments or a variation in the scope of existing facilities/activities is benefit-cost
analysis.
5. Alternatives to SRMC Pricing
A. Zero user charges. Providing a public product for free may, for some already established
services, be appropriate (i.e. economically efficient), particularly if there is excess capacity in a
built facility and wear-and-tear is minimal so that maintenance costs are, on a per-user basis,
small. In such cases SRMC is close to zero. The cost of collecting small SRMC user charges,
including possibly congestion costs for consumers, at bridge toll plazas for example, may exceed
the potential revenues. The efficient practice is such cases is zero charge.
B. Long Run Marginal Cost Pricing. In the presence of significant fixed costs, managers may be
tempted to base charges on long run, rather than short run, marginal costs (or SRMC plus
average fixed costs, AFC) . The user charges will then be higher than the SRMC price and, as a
result, the quantity consumed will be less than optimal. The higher charges will contribute to
covering fixed costs but for facilities with large sunk costs and high economies of scale
(decreasing long run average costs, LRAC), LRMC will still be below LRAC and deficits will
still occur.
C. Average Cost Pricing. This is the most common method of setting public prices in Canada
for all levels of government. However, usually only financial costs, not economic costs, are
employed, for ease of both calculation and explanation to consumers. The result is not
allocatively efficient, unless coincidentally marginal cost equals average cost at the particular
level of consumption. Unless costs are constant, introducing a new higher average-cost fee will
decrease usage, raise average cost and lead to an unintended deficit. If service is then reduced to
stay within budget, the public may complain about paying higher prices for declining service.
© Brian Christie, February 2000, 2001; October 2006
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Otherwise, charges must be increased again and the perception will be that public prices are
escalating beyond the normal level of inflation. Fixed costs are often ignored in average cost
pricing and demand information may be obscured, leaving unanswered important questions about
the efficient long run scale of operation.
D. Average Incremental Cost Pricing. This approach attempts to achieve the best of both
worlds, the full cost recovery of average cost pricing and the efficiency/equity of marginal cost
pricing. Each element of cost, fixed and variable, financial and social (to the degree social costs
can be assigned a monetary value), is attributed to a specific “incremental” decision in producing
the public good or service. Each additional user is then charged the incremental cost that can be
associated with his or her usage.
For example, a traveller passing through an airport creates some part of the requirement for
capacity of the airport (building and roadway construction fixed costs), especially if he or she is
travelling at a peak usage period, generates some maintenance and security costs in and around
the facility, shares in creating the costs of the arrival or departure of the airplane (e.g. air traffic
control), adds to the social costs of associated air and noise pollution, and so on. Efficient
pricing might be approximated by a combination of charges: a departure/arrival tax for passing
through the airport that might vary depending on the time of passage (peak/non-peak), parking
fees and road tolls, a percentage sales tax on the plane fare to reflect the length of flight (air
pollution, need for traffic control), another charge dependent on the size (noise production) of the
plane, etc. While such charges are not in the strictest sense LRMC prices, if visible they may
help to promote efficient behaviour while recovering the costs of providing the air travel support
services. They also may cause consumers to feel (over)taxed at every turn.
E. Multi-Part Tariffs. Commonly employed by public utilities, this approach involves applying
several charges, one or more aimed at the recovery of fixed costs, and others based on usage. For
example, a public utility might charge a fixed monthly charge for access to the service, another
charge for “rental” of equipment, and a variable charge based on the amount of usage. The latter
charge for efficiency purposes should approximate the SRMC price. The access charges can be
used to recover the fixed costs and ensure that the utility recovers all of its costs.
With multi-part tariffs, when groups of users have different demand characteristics, price
discrimination (of the third degree) can be applied and may be useful in achieving efficiency
while increasing revenues. Ramsey prices, related inversely to the elasticity of demand, charge
higher prices to those who are less responsive to increases in prices, presumably because they
have fewer choices or substitutes.
F. Declining Block Pricing. This is another approach involving price discrimination that is
common among public utilities. As the name suggests, the price charged declines for an
individual consumer as the amount consumed increases (price discrimination of the second
degree). The higher initial charges assist in financing fixed charges while ideally the lower
prices at the consumers’ level of consumption are closer to SRMC pricing.
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G. Time-of-Day Pricing. One difficulty with Declining Block Pricing is that it may encourage
increased consumption at times when the delivery system (highway, subway, electrical
distribution) is already facing its greatest demand, adding to peak-load congestion. A response to
this problem, that recognizes that marginal costs may be much lower in off-peak periods than at
peak loads, is time-of-day pricing. Time-of-day pricing is common in the electrical distribution
industries in Europe and has been introduced in the United States for large industrial and
commercial customers. One 1980 study of its application for residential customers concluded the
additional metering costs would significantly outweigh the efficiency benefits. Whether this is
true with more modern information technology is an interesting question.
A variant on time-of-day pricing used in the natural gas industry is the charging of lower prices
for “interruptible” supplies that can be cut off at peak times.
6. User Charges, Benefit-Cost Analysis, and Public Investment
As stated above, the appropriate tool for public sector decision-making regarding the scale of
new public investments or variation in the scope of existing facilities/activities is benefit-cost
analysis.
If a comparison of the present value of the economic costs (financial and social costs) of a public
investment and the present value of the resulting economic benefits (again financial and social)
show that the benefits exceed the costs, then the investment should take place. If the benefits
include a revenue stream that is produced by charging consumers/users a user charge or price,
then the decision about whether or how much investment occurs will depend on how such prices
are set.
If prices have been set below the SRMC price, then the appropriate (efficient) response to unmet
demand may be to raise prices rather than to invest in expanded capacity. Thus the starting point
for consideration of a public investment is to determine the pricing strategy and levels, then
estimate demand and revenue, then use benefit-cost analysis to evaluate the potential investment.
7. A Reference
A practical reference was the Treasury Board of Canada’s Cost Recovery and Charging Policy:
http://www.tbs-sct.gc.ca/archives/opepubs/tb_h/crp_e.asp
It has now been replaced by the Policy on Service Standards for External Fees which has little
substance: http://www.tbs-sct.gc.ca/Pubs_pol/opepubs/TB_H/CRP_e.asp and the User Fees Act
(2004) http://laws.justice.gc.ca/en/U-3.7/264115.html - rid-264122 .
Revised February, 2001, October 2006
© Brian Christie, February 2000, 2001; October 2006
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