Recent Contributions to the Theory of Marginal Cost Pricing: The Problem of Peak Loads

Author(s): M. A. Crew and P. R. Kleindorfer

Source: The Economic Journal, Vol. 81, No. 324 (Dec., 1971), pp. 934-936
Published by: Wiley on behalf of the Royal Economic Society
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 RECENT CONTRIBUTIONS TO THE THEORY OF
MARGINAL COST PRICING: THE PROBLEM OF
PEAK LOADS
J. A. KAY'S recent comment [3] is useful in clarifying some of the im-
portant issues in the debate on public utility, peak load and electricity
pricing. His comment also has certain implications for our contribution to
this debate [1].
Kay derives conditions for the efficient allocation of desired outputs
(q1 . . . qj . . . qn), which prevail over n equal length subperiods among
k plants having running costs at and capacity costs bi, as xij, the output allo-
cated to plant i in periodj. The duals of this problem he interprets as shadow
prices of outputs, vi, and as capacity charges, ui1 and it is these results that
are related to our results. Using Kay's notation, prices for a two-period,
two-plant case would be derived from the following conditions:
vj < aj + uij xij = i-=-1,2,j--1,2
2 i (1)
XiJ < Xi Uiz 0 i = 1,2,5j =1,2 (2)
xi; > O vj ai + uij i=1,2,j-=1,2 (3)
~Xi i
Uii > 0 xii 1,2,j5 1,2 (4)
Xi > O Uil + Ui2
=:bt
i i= 1,2 (5)
Our result is that the optimum
P1 price in period 1 v= a2 + b2 (6)
P2 -V2 - 2a1 + b1 - (a2 + b2) (7)
where period 1 is the peak period and a, < a2, b1 > b2.
The increased precision in our results over those of Kay is obtained by
including cost and demand interdependencies in our model. The relation-
ship between the two results is as follows. We do not assume period outputs
(qj; j 1, . ., n) given, but rather these outputs are determined by the
pricing policy. Given the optimal outputs, of course, one would solve the
linear programme given by Kay to determine the allocation of these outputs
among the plants available. The conditions given by Kay, and previously by
us for the simpler problem treated in [1], prove useful in specifying conditions
on allocative efficiency across plants. These conditions are required for
deriving the optimal pricing policy (see, e.g., the analysis in [2]). In fact,
an economic interpretation of the dual variables, v; and ui1, only becomes
clear when coupled with the overall joint products pricing problem which
determines the desired (optimal) period outputs.
A related point of interest on the efficient allocation of capacity concerns
the cost conditions stated in our note that
b, - b2 < a2-a. < b,-b2 (8)

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DEC. 1971] THE PROBLEM OF PEAK LOADS 935

If the left (respectively right) inequality in (8) is violated then only plant 2
(respectively plant 1) will be used. This condition is important to the peak
load problem with two plants. In supplying output in either period each
kind of plant makes available the ability to supply output (capacity) in the
other period. However, we prove elsewhere 1 that the interaction of cost
and demand implies that plant costs must be within the limits specified by
(8) for both plants to be used. With this result established it is possible to
extend Kay's results to give exact values to his dual variables in terms of the
cost parameters. Several important properties follow which are given
below.
Only one type of plant is used in the shifting peak case. In terms of
Kay's notation where for this case q, = q2, all output is supplied by the
plant with minimum ai and maximum b,.2 Where a firm peak exists and
cost parameters are given by (8), x11 > 0, x21 > 0, x12 > 0, x22 = 0, xI > 0,
x2 > 0. From this and the fact that q1 > q2in a firm peak case, it is possible
by using conditions (1) through (5) and (8) to arrive at our result given in
(6) and (7). From this it is possible further to clarify and extend Kay's
statement that, " Where all techniques operate at capacity, price is demand-
determined at some level between the running costs of the most expensive
plant operating and the cheapest technique not operating." In fact, price
is determined by cost and demand and will be set, for the off-peak period (in
the two-period case), at the cost of supplying output in both periods less the
value of the peak period output. For the peak period it will be set at the
cost of the plant which operates only during the peak period. One quali-
fication is relevant. Where qi = q;, i :# j in the n period case then vi and
v1 are determined as in the shifting peak case by reference to the demand
curves. Finally, costs are minimised by our solution which provides an
explicit optimal solution to Kay's cost minimisation problem in the two-
period, two-plant case.
The task remains to generalise our solution approach to the general
multi-period, multi-plant case, obtaining corresponding cost-operating
results to (8) and determining the corresponding price implications as in
(6) and (7) above. An important input to this task will be Kay's results on
efficient allocation of output among available facilities.
M. A. CREW
Universityof Southampton.
P. R. KLEINDORFER
Instituteof Technology.
Massachusetts
1 In the same appendix as offered in [1] and in part in [2].
2 This is one aspect of the meaning of the assumption by Kav that " . . . techniques dominated
by a single alternative technique have been eliminated " [3, p. 369]. Any techniques with the
same as and higher bi have been eliminated by this assumption.

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936 THE ECONOMIC JOURNAL [DEC.

REFERENCES
1. M. A. Crew and P. R. Kleindorfer, " A Note on Peak Loads and Non-Uniform
Costs," ECONOMICJOURNAL, Vol. 80, pp. 422-3, June 1970.
2. M. A. Crew and P. R. Kleindorfer, " Marshall and Turvey on Peak Load or
Joint Product Pricing," Journalof PoliticalEconomy(forthcoming).
3. J. A. Kay, " Recent Contributions to the Theory of Marginal Cost Pricing:
Some Comments," ECONOMIC
JOURNAL,Vol. 81, pp. 366-7 1, June 1971.

KEYNES ON LLOYD GEORGE

the very admirable edition of Keynes' collected writings, there is a
IN
note at the end of Chapter 3 (entitled " The Conference ") of The Economic
Consequences of the Peace (Volume II, page 34) as follows: "Keynes, at the
suggestion of his friends drafted an addition to this Chapter, concerning
Lloyd George. At the time he was discontented with it and did not include
it. He published it fourteen years later in Essays in Biographywhere a reader
may, if he chooses, find it." It seems that the reader will have to wait until
the publication of that volume of the Collected Works which contains Essays
in Biographyto be told more of the reasons why Keynes postponed the publi-
cation of his essay on Lloyd George; for this the Editors will indeed be able
to draw upon all the evidence of the unpublished Keynes' papers.
In the meantime, as one who has long taken a keen interest in this fasci-
nating question, I would like to make the following observations.
In the Essays (page 32) we find Keynes' own account of the matter. The
note aforementioned gives only part of what he wrote: " I was not content
with it." But he adds, " I was also influenced by a certain compunction.
I had been very close to Mr Lloyd George at certain phases of the Conference,
and I felt at bottom that this, like almost everything else that one could say
about him, was only partial. I did not like to print in the heat of the
moment, what seemed to me, even in the heat of the moment, to be
incomplete. I feel some compunction still."
This is a matter about which each scholar will wish to judge for himself.
In my own opinion the " compunction " was the prime reason fbr not
publishing it in the original volume, and the " discontent with it " was quite
secondary. Indeed, I feel sure that, if he had not had the " compunction,"
he would have taken the trouble to tidy it up and have published it in the
original volume. It is a most masterly piece of writing in the same vein as his
wonderful sketches of Clemenceau and Wilson. He did not intend any of
these sketches to be rounded portraits of the men, but wanted only to bring

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