Friday, July 6, 2012

Utility from Utilities: Principal Agent, Monopoly, and Pepco

Like many DC area customers of Pepco (our local power company) my house lost power last week* The Washington Post  in a recent story on Pepco claimed that the company under performs adjusting for the weather and tree cover that my area has. As someone who has lost power for multiple days at a time several times since moving into my house three years ago today I am sympathetic to this argument. So I put on my economist hard hat and got to thinking.

1. The Issue: a power company like Pepco is an agent that makes decisions about how much effort to put into making sure power is reliability provided. I am a principal who is effected by that decision. The Principal-Agent problem  can lead to many sub-optimal outcomes (no power is sub-optimal!), it also may lead to underinvestment if we can't observe Pepco's effort and random shocks occur. In my class a couple of weeks ago I showed my students a simple model where the probability of making a profit through farming was related to effort (which was costly). When someone worked on their own land they would worked twice as hard as if they worked on someone else who paid them only when a profit from a good harvest is realized. Furthermore, if the land owner paid the worker when a bad outcome occur it would only decrease effort.

2. Perhaps this suggests a solution. We should only pay Pepco when we have electricity (the good outcome)? Oh wait I guess we already do that. Perhaps Pepco's customers should be able to deduct from their bill a rate equal to the average power use from their house on the number of days they lost power (or perhaps some multiple of that the number). I would like to see an economic model of that

3. I don't know much about if Pepco is doing a good job. I also don't have the ability to choose another power company (unless I move). In this case Pepco has a monopoly. For some industries with high fixed costs a monopoly is natural (that's why we call it a natural monopoly), we wouldn't want 8 different companies stringer wires (well maybe we would want another at this point). When public utilities have a monopoly it seems logical to have outside experts evaluate if Pepco is doing a good job. I would like to read less about politicians saying people are fed up with power outages and more actual reports from impartial experts if Pepco is not properly behaving in terms of its natural monopoly.

update Arnold King at AEI has similar thoughts as a PEPCO customer h/t to Dan Rothschild

* I should add I was in San Francisco for all but 4 hours of the power outage, but my wife and daughter were there and they are part of my household utility function which includes utility from utilities.

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