Essay Example on Price cap regulation therefore encourages productive Efficiency

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In contrast to the rate of return regulation price cap regulation should not establish prices to determine a given level of profitability Instead a price ceiling is established and the profitability of the firm then depends on the extent to which it is able to keep its costs below the determined maximum revenue under the cap Jones 2003 Initially the price cap can be set in such a way that forecasts revenue will just cover the forecast operating and capital costs for the period to which the cap applies the firm may then reduce these costs while providing the agreed quality and quantity of service and thereby raise its profits Parker and Kirkpatrick 2005 Price cap regulation, therefore, encourages productive efficiency and consequently is often referred to as incentive regulation



However, if prices diverge from costs of production then allocative inefficiency occurs where the firm is successful in driving down costs consumers suffer prices above the marginal costs of production and investors benefit from supernormal profits Hence periodically the price cap will need to be reviewed and adjusted to reflect the new lower costs of production and thus restore allocative efficiency In general price cap is reviewed in every four to five years Parker and Kirkpatrick 2005 Vogelsang 2002 Price cap normally allows a cost pass-through for any increase in costs of production that are not under the control of the firm's management, In particular, any general rises in costs resulting from inflation in the economy will usually be permitted as cost pass-through to consumers

 The price cap formula which takes the form of retail price index minus X RPI X where X is an efficiency adjustment this factor specifies the rate at which the regulated firm s prices must fall after correcting for inflation in the economy Parker and Kirkpatrick 2005 Crew and Kleindorfer 2002 In the developing countries environment where inflation is more cost pass-through for inflation may be politically risky and the social consequences may become severe because of the impact on prices of essential low price elasticity goods such as water this is especially when wages are not adjusting upwards as quickly as prices





 It can also be economically damaging as higher utility prices fuel further inflation at the economy level So Price cap regulation is problematic for operating in developing countries as these countries usually suffers from higher inflation rates than developed countries Parker and Kirkpatrick 2005 The successful operation of a price cap requires the determination of the correct X efficiency factor to provide the right incentive for management to pursue further efficiency gains without bankrupting the industry Crew and Kleindorfer 2002 In developing countries setting the efficiency factor is likely to be very problematic and the negotiating process may prone to regulatory capture Parker and Kirkpatrick 2005 The regulatory offices are likely to lack reliable historic data on a company's costs to forecast future cost movements with reasonable accuracy Besides the comparison of regulated firms with non regulated firms different regulatory regimes are also known to influence systematic risk We could differentiate between two families of regulation being cost-based regulation Rate of return and incentive-based regulation Price Cap On one hand cost-based regulation takes into account the entire profit function it guarantees a return whatever the economic conditions are 





On the other hand incentive schemes take into account only the price thus firms subject to those regulatory regimes have to face demand or cost shocks Pedell 2006 Therefore the closer the regime is to the incentive scheme the higher will be the risk whereas cost-based regime protects firms from shocks and then induces less risk This theoretical relation is confirmed by Grout and Zalewska 2006 In a regime of the rate of return regulation the regulator sets rates so that a certain target rate of return on capital employed is expected Usually this allowed rate of return is set equal to the cost of capital Pedell 2006 In a theoretical world with a perfect competition where all non-regulated firms earn just about their cost of capital this is clearly an appropriate approach However in a second-best world without perfect competition where nonregulated firms earn on average above normal returns i e returns above cost of capital Pedell 2006



The setting of the allowed rate of return of a regulated utility equal to its cost of capital might cause distortions of investment decisions since the creation of incentives for technological progress which might require a rate of return above cost of capital So one major problem of rate of return regulation is the evidently poor incentives for efficient investment and operation Therefore in many instances more incentive orientated schemes such as price caps were used Pedell 2006 In principle the actual costs of a regulated utility including the cost of capital do not have any influence on regulated rates during the regulatory review period unless the regulatory review process is reopened ahead of schedule





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