The dark side of price cap regulation: a laboratory experiment

Abstract

In a nutshell, price cap regulation is meant to establish a quid pro quo: regulators are obliged by law to intervene only at rare, previously defined points in time, and only by imposing an upper bound on prices; firms are meant to justify regulatory restraint by adopting socially beneficial innovations. In the policy debate, a potential downside of the arrangement has featured less prominently: the economic environment is unlikely to be stable while the cap is in place. If regulators take this into account, they have to decide under uncertainty and also anticipate how regulated firms will react. In a lab experiment, we manipulate the degree of regulatory uncertainty. We compare a baseline when regulators have the same information as firms about demand with treatments wherein they receive only a noisy signal and another when they know only the distribution from which demand realizations are taken. In the face of uncertainty, regulators impose overly generous price caps, which firms exploit. In the experiment, the social damage is severe, and does not disappear with experience.