United States Environmental Protection Agency Water Engineering Research Laboratory Cincinnati, OH 45268 Research and Development EPA/600/S2-85/019 Apr. 1985 v>EPA Project Summary Economic Modelling of Water Supply: An Econometric Analysis of the Multiproduct Firm Hak Youn Kim Research was conducted to develop a comprehensive economic model that could use the neoclassical theory of the multiproduct firm to analyze the production structure of water sup- ply. The project attempts to meet the need for in-depth analysis of the cost and economic structure of water sup- ply. The cost structure of the water sup- ply industry was estimated using the recently refined translog function. Issues addressed included restrictive specifications for water supply technology, input demand function for water supply, scale economies, marginal costs and output supply, and pricing of water and the presence of cross subsidization among residential and nonresidential users. Findings of this research represents the first attempt to apply the translog production function in the water sup- ply area. No comprehensive analysis has been conducted before using the econometric methodology adopted in. this study. This Project Summary was developed by EPA's Water Engineer- ing Research Laboratory, Cincinnati, OH, to announce key findings of the research project that is fully documented in a separate report of the same title (see Project Report ordering information at back). Nature of the Problem The world's present water supply situa- tion is substantially different from that of the past. Scarcity of high-quality water is evident in many locations in the United States and in other countries. Per capita consumption of water has continued to rise with increasing affluence and ur- banization, but many existing water sources have become limited in availability and degraded in quality. Increasing energy costs coupled with inflation and high in- terest rates have raised the costs of pro- viding water. In addition, more stringent environmental regulations (e.g., the Safe Drinking Water Act of 1974) have the potential for increasing water rates. In recognition of growing water supply problems, the United Nations has designated the 1980's as the International Drinking Water Supply and Sanitation Decade. The primary goal is to provide the world with safe water and sanitary disposal of human wastes. In this period of rising costs and impending regulatory changes, the costs of water supply and the factors affecting these costs have taken on new importance. The conventional solution to water sup- ply problems has been to augment sup- plies by expanding the system and acquir- ing the resources as needed to meet the full demand of customers. But the prob- lems of supplying water of acceptable quality are no longer simple. Issues related to substitutabilities among water supply inputs have become important for the policy maker, who must understand implications of increasingly scarce resources. Knowledge of scale economies and their limitations have implications for "regionalization" policies. Also, utility ------- commissions have begun to devote more attention to rate structure reform. The issue of public versus private water pro- viders is becoming more important as communities search for ways to improve management and operation of water sup- ply. As the emphasis on water supply issues grows, so does the need for an in-depth analysis of the cost and economic struc- ture of water supply. Previous research efforts to meet this need have been limited in scope and applicability. The present research seeks to fill that gap. Purpose of the Research The object of this research is to develop a comprehensive economic model that could use neoclassical theory of the multiproduct firm to analyze the produc- tion structure of water supply. In this study, the water supply utility is viewed as a regulated multiproduct firm offering multiple services to various classes of consumers with spatial and temporal variations. Particular attention is directed to the production characteristics of the multiproduct firm. This research project assumes that many issues in water supply can be resolved by applying some basic neoclassical multiproduct production theory. Specifications for the water sup- ply technology used in this research were derived in a manner that is entirely dif- ferent from the neoclassical micro- economic theory. The following issues are addressed in the development of the model: (1) restric- tions posed by existing specifications for water supply technology in view of the neoclassical theory of production; (2) in- put substitution and use in the production process; (3) scale economies; (4) marginal costs and the transformation function of water supply; and (5) second best pricing and the presence of cross-subsidization among customer classes because of inap- propriate pricing structures. Though this research is primarily con- cerned with the analysis of water supply problems, it encompasses many practical problems and issues faced by other utilities and regulated industries. Thus the analytical and empirical methods adopted in this research should provide a useful framework to study not only the water supply industry but also the multiproduct firm in general. Econometric analysis of the general multiproduct firm is far from complete in view of the fact that most of the work in this area has been only preliminary and suggestive without regard to practicality and policy relevance. Methodology of the Research The approach of this research is to estimate the cost structure of the water supply industry using the recently refined translog function. The translog function can deal with multiple inputs and outputs, variable elasticities of substitution among inputs, variables elasticities of transforma- tion among outputs, and variable economies of scale. The theory of duality is explicitly explored in the estimate of the translog cost function. The water supply firm produces mul- tiple outputs for different customer classes such as residential and nonresidential users. Capital, labor, and energy are considered as the major inputs into the production process for the delivery of water and to meet customer demands. Interaction among outputs and inputs is taken into account in the estimate, and various hypotheses of the production structure are tested. The data used represent a cross section of water utilities in the United States for the year 1973. An unusual feature of the methodology used here is the direct incorporation of the firm's operating characteristics into the specifications for the technology. Operating characteristics include capacity utilization and service distance, which are considered important for production and delivery of water supply. With the generalized cost function (which includes operating characteristics in addition to conventional arguments of ouputs and in- put prices), it is possible to obtain insights into the quantitative relationship between costs and operating conditions. Estimates of the translog cost function by ordinary least squares would be im- precise because of possible multi co- linearity resulting from a large number of regressors interacting with one another. Thus our estimates use the iterative Zellner efficient method, which jointly estimates the translog cost function and the input demand functions derived as the first order conditions of cost minimization. The iterative Zellner efficient method is asymptotically equivalent to the maximum likelihood method. Major Findings of the Research Parameter Estimates and Tests of Restrictive Specifications for Technology Estimates of water supply costs presume nonhomotheticity that prescribed differences exist among outputs (residen- tial and nonresidential water supply), in- put prices, and operating variables (capacity utilization and service distance). The translog multiproduct cost function is an adequate description of the technology of water supply. The tests of homogene- ity of outputs, input-output separability, nonjointness, and a Cobb-Douglas form produce results that are significantly dif- ferent from the unconstrained translog cost model. This result suggests that ex- isting specifications placing arbitrary restrictions on the translog multiproduct cost function are inappropriate. In addi- tion, our findings reject the hypothesis that the operating variables should be ex- cluded from the model. Attempts to analyze water supply costs without con- sidering the operating variables would lead to false conclusions about the struc- ture of water supply. Input Demand Function for Water Supply No previous studies have been per- formed to estimate the input demand function for water supply. Capital is a substitute for labor and energy. Substitu- tion between energy and labor is limited to a great extent. Substitution between capital and energy is consistent with the findings of studies in other areas. Energy is an input that requires intensive use in the production process in response to changes in the demand for water and capacity utilization. Furthermore, capacity utilization and service distance have significant effects on input requirements. Thus the inability to account for these variables would lead to a serious problem in estimating of input requirements for water supply. Scale Economies Water utilities experience substantial economies of scale for both residential and nonresidential water supply. The water supply industry is experiencing marked economies associated with the treatment of water, but it suffers from diseconomies with increasing size of distribution network. The economies in treatment override the diseconomies in distribution, however. Furthermore, scale economies are mainly determined by nonresidential water users as opposed to residential users. Marginal Costs and Output Supply Marginal costs of residential and nonresidential water supply are much ------- lower than the actual prices charged. Marginal costs are quite sensitive to changes in outputs, input prices, and operating variables. Marginal costs are estimated from the transformation func- tion of water supply. The latter is convex and illustrates decreasing real opportunity costs of residential and nonresidential water supply. This observation implies an advantage to specializing either in residen- tial or nonresidential water supply. Pricing of Water and Cross-Subsidization Among Customer Classes The economies of scale experienced by water utilities suggest that marginal cost pricing is not feasible. The second best pricing rule has been proposed as an alternative scheme through which prices can be calculated for residential and nonresidential water supply. Surprisingly, the existing price structure is close to the second best pricing optimum. The fact that marginal costs are less than the ac- tual prices indicates that real costs of water supply are much lower than ex- pected. In addition, this study finds no evidence of cross-subsidization among residential and nonresidential users. Empirical findings in this research repre- sent first attempts in the water supply area. No comprehensive analysis has been conducted in the past using the econometric methodology adopted in this research. However, before sweeping or definite conclusions can be drawn from these findings, it is important to verify them using different data. This step is necessary because of the limitations im- posed by the data currently available. Nevertheless, the methodology used in this research should provide fruitful lines of inquiry into the various issues associated with water supply. The full report was submitted in fulfill- ment of Cooperative Agreement No. CR808102020 by the University of Cincin- nati under the sponsorship of the U.S. Environmental Protection Agency. Hak Youn Kim is now with Western Kentucky University, Bowling Green, KY. Robert M. Clark is the EPA Project Officer (see below). The complete report, entitled "Economic Modelling of Water Supply: An Econometric Analysis of the Mult/product Firm," (Order No. PB 85-176 899/AS; Cost: $20.50, subject to change) will be available only from: National Technical Information Service 5285 Port Royal Road Springfield, VA 22161 Telephone: 703-487-4650 The EPA Project Officer can be contacted at: Water Engineering Research Laboratory U.S. Environmental Protection Agency Cincinnati, OH 45268 r U.S GOVERNMENT PRINTING OFFICE: 1985-559-016/27035 ------- United States Environmental Protection Agency Center for Environmental Research Information Cincinnati OH 45268 BULK RATE POSTAGE & FEES PAID EPA PERMIT No G-35 Official Business Penalty for Private Use $300 0000329 PS U S ENVIR PROTECTION AGENCY REGION 5 LIBRARY 230 S DIAR8CRN STREET CHICAGO IL 60£Q4 ------- |