Pricing

    Incentive regulation refers to the design of incentives to ensure that producers keep prices and costs as low as possible. The underlying assumption is that costs are not given but are influenced by the incentives set by the regulatory authorities. If

there was no regulation the privatised monopoly might well slip into the same

bad habits as the state company it replaced. Whether the new regulation achieves

a superior outcome to direct provision of the good or service by the state company depends on the effectiveness of the regulatory system.

    In the UK, following the privatisation of telecoms, gas, water, electricity and railways, regulatory bodies were set up for each industry.Their task was to prevent the abuse of monopoly power and to find ways of promoting competition. This sounds easy, but regulators frequently get into hot water in trying to achieve this objective.

    There are several ways of regulating a privatised industry with strong monopoly

elements:

1. Price # marginal cost. One simple way would be to oblige the monopoly firm to

charge a price equal to marginal cost, and provide a subsidy for any ensuing

loss. The drawback is the cost of the subsidy and the difficulty of determining

marginal cost.

2. Breakeven or average return on capital. Alternatively the regulator could insist on

a price that allows the firm to just break even. This eliminates ‘monopoly’

profits but leaves wide open the opportunity to reap the rewards of monopoly

in other guises .Some regulators use a formula related to rate of return on capital which the monopoly would not be permitted to exceed. This avoids the problem of direct price control, but has the disadvantage of reducing the incentive to firms to minimise costs, once the permitted profit rate has been attained. Rate of return controls have been applied extensively in the US. Not surprisingly there have been frequent disputes over the definition and measurement of rates of return in these cases.

3. RPI minus X. Another possibility is to set maximum prices. The UK authorities

have taken this approach. Various types of price-capping formulas have been

used, known as ‘RPI minus X’, whereby the regulator permits the firm’s price to

rise by no more than x percentage points below the retail  price

index .In a multi-product monopoly, such as telecoms, the regulator may

opt for a tariff-basket method, whereby the authorities decide which products

are placed in the basket and how the various prices are to be weighted. This

usually means permitting lower prices for price-elastic services and relatively higher prices on the price-inelastic part of their provision. While providing

flexibility, regulation can be highly controversial. The public will often

perceive such pricing structures as unfair, even if based on sound economic

principles. Where the output is more homogeneous, such as gas and electricity,

the regulator may use an average revenue target, whereby the predicted rise in

average revenue in the firm is not permitted to exceed RPI minus X.

 

     A key problem of incentive regulation is to determine the efficiency factor X. If X

is set too low, the firm will make excessively large profits and the regulator

will lose face. If it is set too high, the firm will become unviable. In deciding

on the right value of X, the regulator may have to be guided by the expert, but

hardly disinterested, knowledge of the regulated firm. Relations between the regulated and the regulator may become too close and cordial. Another problem is that the formula could act as a disincentive to efficiency if more efficient performance were to lead to subsequent upward revision of X. In practice, rate of return considerations are implicit in setting X. Even the most expert and experienced regulator can make mistakes. The UK electricity regulator, for example, had to undertake a full-scale review less than a year after establishing new price-caps because the regulated firms’ financial performance was much better than estimated. Opportunistic behaviour by the regulator can be highly destabilising.