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Keith Gilsdorf

Keith Gilsdorf. Testing for Subadditivity of Vertically Integrated Electric Utilities Southern Economic Journal, 1995. What If…. What If…. An electrical distribution firm has economies of scale due to networking efficiency. An electrical generation firm does not exhibit economies of scale.

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Keith Gilsdorf

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  1. Keith Gilsdorf Testing for Subadditivity of Vertically Integrated Electric UtilitiesSouthern Economic Journal, 1995

  2. What If…

  3. What If… • An electrical distribution firm has economies of scale due to networking efficiency. • An electrical generation firm does not exhibit economies of scale

  4. What If… • An electrical distribution firm has economies of scale due to networking efficiency. • An electrical generation firm does not exhibit economies of scale • Could economies of integration exist?

  5. If economies of integration create subadditivity, vertically integrated firms could be natural monopolies. • Deregulation of these firms might have unintended effects.

  6. To answer the question • For simplicity, generation and transmission are treated as two goods in a multi-product example. • Gilsdorf utilizes a test for subadditivity.C(uo) < C(u*) + C(uo- u*)for all u* < uo.

  7. Procedure • Gilsdorf gathers data from 72 privately-owned electric utility companies. “These utilities accounted for over 72 percent of investor-owned conventional steam generation in 1985” • An estimated cost function can be carefully tested for subadditivity.

  8. To construct the test, assumptions are required. • A generic cost function can be fitted to observations in the data set. However, it should not be extrapolated beyond the domain of the data set.

  9. The smallest output level used for statistical inference must be at least as large as the minimum observed output level. This applies to both goods (generation and transmission). UA = (G* + Gm, wT* + Tm)UB = ((1 - Φ)G* + Gm, (1-w)T* + Tm),

  10. Go = 4G* + Gm + (1 - Φ)G* + Gm • Go = G* + 2Gm; • Go - 2Gm= G*; • To = wT* + Tm+ (1 - w)T* + Tm • To = T* + 2Tm • To - 2Tm = T*.

  11. Secondarily, the ratios of generation and transmission for any hypothetical firm estimated by the regression must be within the range observed in the data. RL < (Φ G* + Gm)/(wT* + Tm)< Ru; RL < ((1 - Φ)G*+ Gm)/((1 - w)T* + Tm) < Ru;

  12. Something a little more familiar… • C(uo) = C(uA + uB). • And less familiar • Sub(Φ,w) = (C(uo) - C(uA)-C(uB))/C(uo).

  13. ECON 440 REVIEW SESSION • What does a cost function look like? • A cost function predicts the minimum cost that must be incurred (with an optimal input mix) as a function of desired output, input prices, and some other relevant variables.

  14. ECON 440 REVIEW SESSION • What does a cost function look like? • A cost function should be non-negative, homogenous of degree k=1 with respect to input prices, concave, and monotonic with respect to input prices. • Marginal costs should be positive

  15. ECON 440 REVIEW SESSION • The translog cost function takes a form such as the following:

  16. Variables • Two forms of output: generation and transmission. • Fuel price, Wages, an index proxy for capital costs • Three ‘hedonic’ variables: consumer density, capacity utilization, and the share of total sales that go to ‘ultimate’ or ‘final’ customers. • For the dependent variable, total cost is used.

  17. Empirical Results: • When subadditivity is estimated by Evans and Heckman’s formula, only 16 of the 72 firms have the requisite negative estimate. None of the estimates are significantly different from zero. • At the sample mean, small degrees of subadditivity exist. However, no estimates are significantly different from zero.

  18. Empirical results: • Gilsdorf cannot reject the hypothesis that vertically integrated firms are additive. • This conclusion does not support the hypothesis that vertically integrated firms are natural monopolies. • The data does suggest that economies of scope can occur.

  19. Policy implications? • If integrated utilities are not natural monopolies, pro-competitive public policy may be effective. • If economies of scope exist between generation and transmission, total divestiture is not prescribed.

  20. As a bonus: • The effects of capacity utilization and the percentage of generation that is sold to final customers can also be analyzed using partial derivatives of the cost function with respect to those variables. • ln C/ln CU < 0 • ln C/ lnPULT < 0

  21. As a bonus: • The derivative with respect to capacity utilization is significantly negative in ten cases, suggesting that idle production capacity increases total costs. • The derivative with respect to ‘ultimate’ sales (sales mix) is significantly negative in nine cases, but significantly positive in one.

  22. Bonus policy implications: • Policy designed to increase capacity usage improves efficiency and lowers costs. • The sales mix analysis suggests that divestiture of distribution networks may be harmful, as they suggest some economies of scope from diversifying sales between final customers and unaffiliated distribution firms.

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