The long-run inefficiency of block-rate pricing

In this paper we compare two regulation instruments, flat-rate and increasing block-rate pricing. The analysis applies to a competitive industry with free entry. Charge for irrigation water is a concrete example. It is shown that flat-rate pricing leads to a first-best social optimum, while with block-rate pricing where the highest block set at the marginal cost, there is over production, firms are too small, and loss of economic surplus occurs. Moreover, first-best is not implementable by increasing block-rate pricing. This is in contrast to the commonly accepted view that block-rate pricing is superior to flat-rate pricing by allowing for income redistribution while preserving efficiency. Several second-best situations are analyzed to show: 1) Block-rate pricing with the highest block at the social marginal cost is optimal when the regulator must preserve the number of firms. 2) Water pricing alone cannot implement social optimum subject to a constant level of agricultural production. 3) Lobbying and political pressures, which force the regulator to sustain a constant average water price, result in optimal block-rate pricing with the highest block below the social marginal cost.