Regulating by Capping Prices

Toward improved and practical incentive regulation

“…If the benchmark inflation index and the allowed productivity offset reasonably track company costs and actual productivity, revenue requirements can be expected to be met continually over time. If consumer demands are stable, individual prices may evolve toward second-best Ramsey levels or, if the particular utility service is competitive, toward sustainable levels (Brennan 1989); for competitive services, price caps afford efficient incentives to the firm to diversify and produce in noncore markets (Braeutigam and Panzar 1989). All of these results are possible without regulator knowledge of marginal cost and demand elasticities.…”

“…Neu (1988) and Brennan (1989) have demonstrated that a utility with appropriate foresight and asymmetric future customer growth can strategically price individual services in a manner that would interfere with convergence to Ramsey prices in the long run. Additionally, in order to enjoy periods of temporary price deregulation, utilities could continually redefine existing services as "new" services (with some perfunctory modification in the basic service) unless carefully supervised.…”

“…In giving the utility a financial incentive to reduce costs, price caps may give it an incentive to reduce service quality as well. Second, the indexing problems identified in Section 3 may again arise; i.e., particular price-movements may be politically unpopular, prices may converge under asymmetric growth to an inefficient long-run equilibrium (Neu 1988;Brennan 1989), and the utility may introduce "new" services to enjoy temporary, if not permanent, deregulation. Furthermore, if new services are to be kept permanently outside of the index, Kwoka (1991) points out yet another difficulty with an index ceiling; the utility may introduce a "new" service that is a trivial modification of an existing core service but price it a bit below.…”

“…In allowing regulators the option to adjust starting tariffs (which are presumably fair) evenly through the long run, the mechanism potentially can avoid the danger of asymmetric price adjustment (but also preserves any inefficiencies in the starting tariff structure); individual adjustment of fair tariffs avoids the indexing problems identified in Neu (1988), Brennan (1989), and Kwoka (1991). Alternatively, regulators may deregulate each individual price and only enforce an aggregate adjustment rule; under these circumstances, the modified VF mechanism may converge to Ramsey or sustainable prices in the long run.…”

The effects of incentive regulation in the telecommunications industry: A survey

“…Among the many formal analyses of the merits and drawbacks of price-cap regulation are: Braeutigam and Panzar (1989), Brennan (1989), Brown, Einhorn and Vogelsang (1989), Cabral and Riordan (1989), Lewis and Sappington (1989), Schmalensee (1989), Isaac (1991), Sappington and Sibley (1992), Laffont and Tirole (1993), and Gasmi, Ivaldi, and Laffont (1994). l0 In practice, the X-factor does not always reflect realized or anticipated productivity gains.…”