232 CHAPTER | 8 Efficient Pricing of Electricity P Supply (marginal cost) CS P* PS Demand Y* Y FIGURE 8.1 Consumer and producer surplus in a competitive market paradigm. Marginal cost pricing [the supply curve above average variable cost (not shown)] maximizes total welfare, which is equal to the consumer surplus (CS) plus producer surplus (PS). Thus, a pareto-efficient outcome is attained. is the reason that regulated firms often charge both fixed and variable charges to end-use customers, 1 the latter of which should be based on marginal cost. DEBATE ON THE OPTIMAL PRICING OF ELECTRICITY: A BRIEF HISTORY The idea of marginal cost pricing is not new; for centuries, economists have espoused that pricing goods and services at marginal cost is efficient both allo- catively and productively. In the case of electricity, it was actually two engi- neers who, in the late 19th century, argued for marginal cost pricing, also known as time-of-use or real-time pricing. The following excerpt contains a nice synopsis of the history of the debate on the optimal pricing of electricity, which requires an accurate estimation of the marginal cost of providing service to various types of end users (residential, commercial, industrial, etc.). In the introduction to his treatise on demand response and efficient pricing that appeared in the USAEE Dialogue in August 2007, John Kelly (president of the American Public Power Association) wrote: Renewed Interest in Demand Response, but "Whither the Economic Rationale for Efficient Pricing?" This is not the quarrel here but rather the fact that it is often the case that variable charges do not necessarily reflect the true marginal cost of supplying electricity. 1