Public utility pricing and capacity choice under risk: A rational expectations approach

Over the last two decades there has developed an extensive literature on the theory of public enterprise pricing and capacity choice under uncertainty. A major concern has been the analysis of the rationing of consumers in states in which demand exceeds available system capacity. An issue that has been largely ignored however is the effect that consumers' probability of being rationed (system reliability) has on their demand for the service. In this paper we develop a model that reflects the intuitive notion that a more reliable service is a higher quality service, so that an increase in system reliability shifts consumers' demand curves outward. We then incorporate this effect into our analysis of the utility's optimal pricing and investment rules. Finally, we demonstrate how the value of reliability can, in principle, be estimated from generally available demand data.