You have been retained as an analyst to evaluate a proposal by your city’s privately-owned water company to increase its rates by 100 percent. The company has argued that at the present rate level, the firm is earning only a 2 percent rate of return on invested equity capital. The company believes a 16 percent rate of return is required in today’s capital markets.

Assume that you agree with the 16 percent rate of return proposed by the company.

1. What factors need to be considered when setting rates designed to achieve this objective?   
2. Would your analysis differ if you knew that individuals were prohibited by law from drilling their own wells? What impact would this have on the price elasticity of demand?                                                               
3. Water companies have a large proportion of fixed costs as compared with variable costs. How does this fact influence your analysis?
4. Do you believe this firm (a monopolist) can earn its required 16 percent rate of return even if the public utility commission agrees this is a reasonable rate of return?