Regulation: Economics and Price Cap Essay

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Regulation

Generally, government provision is often motivated by a desire to correct various types of market failure. Especially, Regulation of industry is based on the some industries are natural monopolies. Regulation is requires to ensure the monopolist does not abuse it market power. Therefore, there are 2 main regulatory regime most widely used in the UK and the US to prevent the abuse of market power.

Firstly, rate of return regulation (ROR) is the main regulatory regime in the US. This can be calculated as following formula :

Under the rate of return regulation, the regulator allows the firm to set a price that covers costs and allows a mark-up for profit. Price reviews carried out frequently. However, this may cause little incentives to the firms to minimize its costs. For example, if costs are fall, then the firm could earn a return exceeding the required rate during the waiting year. This shows the regulatory lag will cause incentive for firm to use the effective cost control

Price cap regulation is designed by the UK which imposes a specific limit on the prices firms are permitted charge. Normally, this can be calculated as : RPI – x-Factor.
Over the past decade or so, the price cap approach has become increasingly common internationally because it is thought to give firms stronger incentives to be efficient. Usually, in the UK and many other European countries do the price cap regulations review every 4 or 5 years. Also during the review the

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