The impact of cross-subsidies on utility service quality in developing countries

Low service quality in the utility sector (electricity, water, natural gas, etc.) is a major obstacle to economic advancement in developing countries. This paper provides an explanation for low quality of service through examining the rational responses of firms (utility providers) to subsidy policy. Cross-subsidies are widely applied to spur poor households’ consumption of utility services. This raises the issue of whether charging lower prices to poor households, while boosting their consumption, induces firms to lower the quality of service received by these households. We specify an analytical model in which the government may not fully cover the firm's deficit from subsidizing poor households. Our main findings are: 1) when government transfers fail to cover this deficit, the firm reduces quality for subsidized consumers; 2) the difference in quality across consumer income groups might be reduced by an increase in the amount of government transfers. This paper also identifies several directions for future research, including the impacts of cross-subsidies on social welfare and a better design of subsidy funding mechanism.