Incentive Regulation

An overview
• Regulatory lag is an imperfect method of rewarding
the efficient, and penalizing the inefficient,
regulated monopolist.
• The costs of the regulated firm may be rising or
falling for reasons unrelated to the firm’s efficiency.
• One way of aligning the level of profits of a firm to
its performance is to permit rate changes based on
changes in an industry-wide cost index (or ‘price cap
regulation’).
• This process is similar to that of market competition,
where firms that have a lower cost earn
supracompetitive profits in the short run.
• In the long run, as the more efficient firms expand
production to close the gap between marginal cost
and market price, the price level falls.
• To continue obtaining supracompetitive profits, the
firms will have to find new ways of reducing cost.
• Similarly, under the index-approach, the efforts of
firms to beat the average with superior cost
controls cause the average to fall.
• This approach is to be distinguished from the
automatic pass-throughs (eg of fuel-input costs of
the 1970s )
• In practice, needless to say, incentive regulation is
not a perfect substitute for a market.
• A particularly serious problem is the incentive of a
price-capped firm to reduce quality in order to reduce
its costs without a price reduction.
• Another concern is that incentive regulation by its
nature cannot take account of certain factors pushing
up the regulated firm’s costs.
• In a market, a firm that experiences a cost not borne
by its competitors is constrained.
• A firm, that cannot make any adjustment may face
bankruptcy.