Regulation content slideshow. Designed for the Economic A level qualification. Can be used in revision and in class. Subtopics Intro to Regulation Price Capping: RPI-X & RPI+K Profit Capping: Rate-of-Return Performance Targets Self-Regulation

1. Regulation
(U6th)
Upper 6th Micro
Government Intervention
(U6th)

2. Intro to
Regulation
Regulation (U6th)
Mr O’Grady

3. Intro to Regulation
Definition: Government imposed rules to restrict the commercial freedom of
private businesses to set their own prices/quality
Aims of Regulation: increase efficiency, improve quality of service and protect
consumers from unwarranted price rises
Especially in the case of natural monopolies
Diagram: Natural Monopoly
EoS are so great (MES is beyond the AR curve), that
only the largest firm will ever survive and dominate
Dominant firm can always undercut smaller
firms/new entrants due to natural ‘monopoly
leadership position’, and gain market share
A lack of viable competition, X-inefficiency results
Can never be allocatively efficient as at MC = AR
occurs when ATC > AR (subnormal profit)
Regulation role: a surrogate to competition
Forces the firm’s price down towards AR = AC
Quantity
C/R
AR
MR
MC
AC
QPM
pPM
pAE
QAE
cAE

4. Price Capping:
RPI-X & RPI+K
Regulation (U6th)
Mr O’Grady

5. Price Capping
Definition: a limit on the extent that a firm can raise its price in a given period of
time
Caps can be based on several factors including efficiency savings, investment provision and
inflation
All utility industries in the UK are subject to caps, as their outputs are vital necessities
Quantity
C/R
AC
MC
D = AR
MR
qPM
pPM
pCap
qCap
Diagram: Price capped monopoly
A rational, unthreatened monopoly would price a
pPM as this allows it to maximise profits
By capping the price at pCAP they monopoly still
makes healthy profit, but consumers are not
exploited by high prices
The firm moves closer to allocative efficiency
(P=MC)
A greater quantity is consumed (qCAP> qPM)
Welfare increases

6. RPI – X
RPI - X: Allows price increases at the rate of inflation (RPI) minus an expected
efficiency gain for the year -the ‘X’ value (reviewed every 5 years)
X is the amount by which they have to cut prices by in real terms
E.g. 1 if X = 4% and RPI inflation = 5%…firm may increase price by up to 1%
E.g. 2 if X = 4% and RPI inflation = 3%…firm must decrease price by at least 1%
Rationale: ‘X’ value reflects the firm’s annual percentage reduction in AC
I.e. an efficiency target for the year
To maintain the real value of profits, the firm will need to achieve its efficiency target
To increase profits, it must exceed its target (cut costs by more than ‘X’ value)
This increases the incentive for productive/dynamic efficiency
Value of X: X is based on a firm’s past performance and that of the other firms in
the industry
X acts as a proxy for competition and incentivises firms to innovate
Key Benefit: Flexibility
Price cap can be easily removed if the market is viewed to be competitive
E.g. Ofcom ended BT’s price cap in 2006

7. Problems with RPI – X
Setting the level of X: X has often been set too low as regulators underestimate
possible cost reductions and then have to change X abruptly to compensate
But if X is too high, this may compromise the firm’s investment plans and lead to lower
quality service
Power distribution: A lot of power is given to a regulator who is unelected and
largely unaccountable
Myopia: Industries may suffer from short-termism as they focus on the RPI – X
target and cannot plan long-term due to uncertainties with the formula changing
Regulatory capture: When regulators act in the industry’s interest, rather than the
consumers’, possibly due to regulators getting too close to industry managers
(leading to lenient price caps).
Price mechanism distortion: RPI – X keeps price low, but this limits the signalling
function of price
A lower price could put off potential new entrants, reducing actual competition in the LR
However, this is not an issue for natural monopoly

8. RPI + K
RPI+K: Price can rise by RPI plus an allowance to fund the purchase of capital
equipment (the ‘K’ value) required to meet certain quality standards
Examples: Occurs in the water industry (to meet EU water purity standards) and in the rail
industry (to meet safety standards)
Key advantage: promotes investment in the industry and dynamic efficiency
Generates cost savings that could be passed onto consumers
Composite price cap: an alternative could be RPI – X + K or the formula for water
is RPI + K + U, where K is the amount allowed for investment, and U is any unused
'credit’ rolled over from previous years.
I.e. if K is 3% in 2019, but a water company only 'uses' 2%, it can add the unused 1% to K in
2020
Key evaluation: Price cap only applies to variable charges and not connection
charges or other fixed charges, therefore unwarranted price rises can occur here
E.g. broadband monthly fees maybe slowed to rise, but set up costs and repair prices could
inflate massively

9. Profit Capping:
Rate-of-Return
Regulation (U6th)
Mr O’Grady

10. Rate-of-Return (RoR)
RoR: where regulators set a maximum rate of return (profit) on a firm’s capital
The cap on profits should be equal to a ‘competitive’ rate of return (normal profit)
Any supernormal profits are confiscated (Windfall Tax) – i.e. taxed at 100%
E.g. US utilities markets in the 20th Century
Equation: A firm’s rate of return can be calculated using the following formula:
RoR =
Profit
Value of capital assets
x100
Advantages:
RoR regulation enables prices to remain flexible.
If the costs of production go up, firms are able to adjust their prices accordingly.
This means that the firm’s rate of return is consistent
RoR regulation encourages firms to invest more in capital.
As the rate of return is consistent – and not eroded by higher costs – this makes the
profitability of investment stable and more likely to occur
Also, as firms increase their capital stock they get to keep more profit, incentivising
investment

11. Problems with RoR
Pricing: Prices are set to AC, not the socially optimum MC
Total welfare is therefore not fully maximised
Investment: Little incentive to introduce new cost saving technology/efficiency
measures.
Regulator would simply insist on lower profit.
Efficiency: Firms have an incentive to let costs rise such as salaries/luxury offices
and then pass these costs on to consumer
Maintaining profit margin/ROR
Subjective: Hard to determine an unobserved level of ‘normal profit’
Regulatory capture could lead to lenient profit targets (too high)
Or regulation could too harsh, firms are going to leave as the make subnormal profits
There is asymmetric information and cost of analysis for regulators

12. Performance
Targets
Regulation (U6th)
Mr O’Grady

13. Performance Targets
Performance Targets (AKA Yardstick Regulation): Where regulators set
quantifiable targets which aim to improve standards of customer service
Compensates for non-price competition
E.g. Answer all phone calls within three rings, 80% of buses running within 5 minutes of their
published time, 92.5% of first-class mail to be delivered by the next day
Workings:
More labour and/or investment in capital required to meet targets
Base targets on best performing firms in Europe
Failure to meet targets leads to fines
Problems of Performance Targets:
Same problem of regulatory capture leading to lenient performance targets
Performance targets may focus so much attention and resources on one small area of
operations
Other parts of the business not subject to performance targets begin to suffer

14. Self-Regulation
Regulation (U6th)
Mr O’Grady

15. Self-Regulation
Definition: members of an industry monitor their own adherence to standards,
rather than have an independent agency or governmental regulator monitor and
enforce them
E.g. In 2002, the main UK supermarkets established a voluntary code of conduct following
criticism by the Competition Commission in 2000
Key Advantage: Cheap to for government as they don’t need to fund regulators
Key Evaluation: Unlikely to provide sufficient incentive for firms to behave
responsibly

16. Where next?
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