Optimal pricing and capacity choice for a public service under risk of interruption

Fred Schroyen () and Adekola Oyenuga ()
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Fred Schroyen: Department of Economics, Norwegian School of Economics and Business Administration, N-5045 Bergen, Norway
Adekola Oyenuga: Department of Economics, Norwegian School of Economics and Business Administration, N-5045 Bergen, Norway

No 2010070, LIDAM Discussion Papers CORE from Université catholique de Louvain, Center for Operations Research and Econometrics (CORE)

Abstract: We develop rules for pricing and capacity choice for an interruptible service that recognise the interdependence between consumers' perceptions of system reliability and their market behaviour. Consumers post ex ante demands, based on their expectations on aggregate demand. Posted demands are met if ex post supply capacity is sufficient. However, if supply is inadequate all ex ante demands are proportionally interrupted. Consumers' expectations of aggregate demand are assumed to be rational. Under reasonable values for the consumer's degrees of relative risk aversion and prudence, demand is decreasing in supply reliability. We derive operational expressions for the optimal pricing rule and the capacity expansion rule. We show that the optimal price under uncertainty consists of the optimal price under certainty plus a markup that positively depends on the degrees of relative risk aversion, relative prudence and system reliability. We also show that any reliability enhancing investment - though lowering the operating surplus of the public utility - is socially desirable as long as it covers the cost of investment.

Keywords: service interruption; rationing; system reliability; second-best pricing; capacity (search for similar items in EconPapers)
JEL-codes: D11 D24 D45 H42 (search for similar items in EconPapers)
Date: 2010-11-01
New Economics Papers: this item is included in nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:cor:louvco:2010070

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