ChainWhat it assumes · how to break it
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A regulator such as Ofwat or Ofgem caps the prices a utility can charge, for example allowing prices to rise each year by the rate of inflation minus an efficiency factor X (RPI − X).
1
As a result, the firm cannot charge its profit-maximising price where MC = MR and must keep its prices at or below the cap.
price cap · RPI − X
price cap · RPI − X
Assumes: The cap is set below the price the firm would otherwise charge.
But: If the cap is generous, it may barely bind and prices change little.
2
This means prices rise more slowly than inflation, so they fall in real terms each year by X.
real prices
real prices
Assumes: X is positive.
But: Where heavy investment is needed, a regulator may let prices rise faster than inflation to fund it, as with the RPI + K formula once used in the water industry.
3
Since the regulator sets X from estimates of how far the firm can cut costs, the cap pushes prices towards the level an efficient competitive firm would charge.
efficiency factor X
efficiency factor X
Best link to attack
Assumes: The regulator has accurate information about the firm's costs.
Assumes: The regulator has accurate information about the firm's costs.
But: The firm knows its costs far better than the regulator and has an incentive to overstate them, so X may be set too low.
End
Prices fall in real terms and move closer to the level a competitive market would produce.
Evaluation chain
- E1However, the fall in price depends on the regulator setting X accurately.
- E2Because the firm knows far more about its costs than the regulator and has every reason to overstate them, the regulator faces asymmetric information.
- E3As a result, X may be set too low, so the cap barely restrains prices, and over time the regulator may come to share the industry's view (regulatory capture).
- E4So price caps cut real prices only as far as the regulator's information allows; with poor information, prices may stay well above the competitive level.
Caps are usually fixed for a review period of several years, so prices respond to changes in costs only at each review.
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Questions this answers
- Assess the effectiveness of price caps in regulating the prices charged by utilities.
- Explain how an RPI − X price cap works.
- Discuss whether price regulation is better than competition for controlling the prices of a natural monopoly.
Diagram
Monopoly diagram with a horizontal price cap below the profit-maximising price: the firm's AR becomes horizontal at the cap until it meets the demand curve, MR jumps down at that point, and output rises while price falls.
Reverse and related
Removal of a price cap → the firm moves back to its profit-maximising price where MC = MR, so prices rise.