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Open Access Publications from the University of California

Nonlinear Pricing in Energy and Environmental Markets

  • Author(s): Ito, Koichiro
  • Advisor(s): Borenstein, Severin
  • Hanemann, Michael
  • et al.

This dissertation consists of three empirical studies on nonlinear pricing in energy and environmental markets. The first investigates how consumers respond to multi-tier nonlinear price schedules for residential electricity. Chapter 2 asks a similar research question for residential water pricing. Finally, I examine the effect of nonlinear financial rewards for energy conservation by applying a regression discontinuity design to a large-scale electricity rebate program that was implemented in California.

Economic theory generally assumes that consumers respond to marginal prices when making economic decisions, but this assumption may not hold for complex price schedules. The chapter "Do Consumers Respond to Marginal or Average Price? Evidence from Nonlinear Electricity Pricing" provides empirical evidence that consumers respond to average price rather than marginal price when faced with nonlinear electricity price schedules. Nonlinear price schedules, such as progressive income tax rates and multi-tier electricity prices, complicate economic decisions by creating multiple marginal prices for the same good. Evidence from laboratory experiments suggests that consumers facing such price schedules may respond to average price as a heuristic. I empirically test this prediction using field data by exploiting price variation across a spatial discontinuity in electric utility service areas. The territory border of two electric utilities lies within several city boundaries in southern California. As a result, nearly identical households experience substantially different nonlinear electricity price schedules. Using monthly household-level panel data from 1999 to 2008, I find strong evidence that consumers respond to average price rather than marginal or expected marginal price. I show that even though this sub-optimizing behavior has a minimal impact on individual welfare, it can critically alter the policy implications of nonlinear pricing.

The second chapter " How Do Consumers Respond to Nonlinear Pricing? Evidence from Household Water Demand" provides similar empirical evidence in residential water markets. In this paper, I exploit variation in residential water pricing in Southern California to examine how consumers respond to nonlinear pricing. Contrary to the standard predictions for nonlinear budget sets, I find no bunching of consumers around the kink points of their nonlinear price schedule. I then explore whether consumers respond to marginal price, expected marginal price, or average price when faced with nonlinear water price schedules. The price schedule of one service area was changed from a linear price schedule to a nonlinear price schedule. This policy change lead to an increase in marginal price and expected marginal price but a decrease in average price for many consumers. Using household-level panel data, I find strong evidence that consumers respond to average price rather than marginal or expected marginal price. Estimates of the short-run price elasticity for the summer and winter months are -.127 and -.097, and estimates of the long-run price elasticity for the summer and winter months are -.203 and -.154.

I conclude with "The Effect of Cash Rewards on Energy Conservation: Evidence from a Regression Discontinuity Design" to examine the effect of an alternative form of nonlinear pricing that was developed to provide an explicit financial incentive for conservation. In the summer of 2005, California residents received a 20% discount on their summer electricity bills if they could reduce their electricity consumption by 20% relative to 2004. Nearly all households automatically participated in the program, but the eligibility rule required households to have started their electricity service by a certain cutoff date in 2004. This rule generated an essentially random assignment of the program among households that started their service right before and after the cutoff date. Using household-level monthly billing records from the three largest California electric utilities, I find evidence that the rebate incentive reduced consumption by 5% to 10% in the areas where summer temperature is persistently high and income-level is relatively low, but the estimated treatment effects are nearly zero in other areas. To save 1 kWh of electricity, the program cost 2 cents in inland areas, 91 cents in coastal areas, and 14.8 cents for all service areas.

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