Regulatory Issues with Vertically Disintegrated Public Utilities: A Transaction Cost Analysis

The traditional structure of public utilities has been one of extensive vertical integration, where multiple stages of production were conducted under the umbrella of the regulated firm. Prices for the final product were generally determined by rate-of-return regulation, which in theory permitted the firms to price in a fashion that generated revenues sufficient to cover variable costs and allowed a fair return to stockholders on their capital investment. Pricing of products at intermediate levels of production became a concern only to the extent that it could be used as a tool to circumvent the regulatory process, as in cases where the firm might set such prices strategically in order to shift costs from regulated to unregulated subsidiaries1 or when political concerns dictated pricing to implement cross-subsidization between divisions of a regulated firm.2 Overall, pricing of intermediate goods tended to be viewed as an internal matter, and left largely to the discretion of the regulated firms.