An Incentive-Pricing Analysis Of Price-Cap Regulatory Regimes

Regulation is of paramount importance when there are natural monopolies in the society, since the existence of monopolies alone is costly to the society due to deadweight losses from mark-up pricing. Laffont (1994) describes regulation as two-fold using the incentive-pricing dichotomy and divided the regulation problem into having separate mechanisms for cost compensation and pricing structure. In this paper, I analyzed the pricing structure proposed by price-cap regulations (i.e., a pure price-cap regulation, a price-cap regulation with downward price flexibility, and a price-cap regulation with revenue sharing mechanisms) with respect to its incentives for cost minimization and product innovation. The differences in benefits of the different types of price-cap regulations depend on the availability and observability of cost information. On one hand, it shows that when information on consumer preferences is available, a pure price-cap may be sufficient. On the other hand, when the regulator has some knowledge of the firm’s cost structure and none of consumer preferences, then it may be better to implement a price-cap with downward price flexibility. When neither the regulator nor the regulated firm has knowledge of the cost structure, then a price-cap with revenue sharing mechanisms may be most fitting since it provides the greatest incentive for the firm to obtain information to minimize its costs. Other policy implications undertaken in this paper include (i) aiming for a more efficient tax system such that the social cost of transfers to the regulated firm, if any, is minimized; (ii) including a provision for quality of products and services; and (iii) highlighting the role of information gathering, auditing, and accounting institutions in the implementation of a well-functioning incentive regulation mechanism.

The monopolist’s adoption of mark-up pricing poses a threat to social welfare because of the existence of deadweight losses. Basic microeconomics prescribe competition as the solution that will drive prices down to marginal cost; however, in cases where the viable number of firms is limited to only one or a few players due to high barriers to entry (e.g., high fixed costs and technological requirements), the existence of a monopoly is inevitable. Take for instance an industry where fixed costs are high, mark-up pricing is employed in the spirit of production efficiency since constraining prices to be equal to marginal costs will not fully recover costs and, thus, may risk the firm to bankruptcy and may eventually lead to a missing market, which is an even greater problem.When the existence of a monopoly is justified as in the foregoing example, regulation becomes a central concern of microeconomics. Under complete information, the solution may somewhat be straightforward. Subsidizing fixed costs, providing tax breaks, and implementing perfect price discrimination, among some solutions, will allow firms to produce at the competitive quantity, thus eliminating deadweight losses and, consequently, maximizing social welfare. In practice, though, no one person is ever endowed with complete information since uncertainty and information asymmetries are central to reality. This extends the regulation problem to not only the minimization of deadweight losses but also the minimization of socially costly rents resulting from the informational advantage of regulated firms. Laffont (1994) refers to this regulation problem as the incentive-pricing dichotomy.

Incentive-Pricing Dichotomy

Laffont (1994) stated several issues with the two traditional regulatory paradigms of (1) cost of service regulation and (2) Ramsey-Boiteux regulation. On one hand, under the former, a rate of return above the market rate is guaranteed, thus ensuring the firm’s long run commitment since the risk of bankruptcy is kept low; however, it lacks the theoretical vision that would justify giving the firm some amount of rent. On the other hand, the latter relies on a well-defined optimization procedure to determine the appropriate pricing, but heavily relies on complete information, thus making it unattractive, or impossible even, to apply in practice.

To address the issues faced traditionally, Laffont (1994) integrated these paradigms into a single concept by adopting the principal-agent model with incomplete information and suggested propositions that eventually led to the development of incentive regulation mechanisms that includes cost reimbursement and some type of transfer from the regulator to the regulated firm.

Laffont prescribed that “the optimal procurement contract is implemented by a menu of linear cost sharing rules in which firms self-select themselves.” The objective of offering a menu of contracts, is the truthful revelation of costs and efficiency type (characterized by the amount of effort) and minimization of rent. Assuming a two-type firm scenario, the contract, offered to efficient firms, would involve the provision of first-best effort, firms will truthfully reveal themselves at the expense of giving them some rent, lower in amount than the case where efficient firms disguise themselves as inefficient firms. The contract, offered to inefficient firms, would involve the provision of second-best effort, which is lower than the first-best effort of the inefficient type, i.e. (a downward distortion of effort). A closer look at the second-best contracts offered to inefficient firms poses an allocative efficiency issue because of , which increases the amount of deadweight loss in the society; thus, implying an inherent tradeoff between minimizing the social cost of informational rents and the deadweight loss arising from allocative inefficiency, that is the incentive pricing dichotomy. In other words, the desire to minimize transfers to the regulated firm is in contrast with the regulator’s desire to minimize cost.

The thought exercise discussed in the two-type scenario can as well be generalized to a continuum of efficiency types, where the amount of rent or transfers is inversely related to. The incentive regulation mechanism will then leave most rent to the lowest cost / lowest effort firms, no rent to the highest cost / highest effort firms, and some rent to the intermediate types. Conversely, the effort level required from the lowest cost firms is optimal, while the effort level required from the highest cost firms is distorted the most; whereby the distortion levels down as.

In sum, an incentive regulation mechanism requires two things: one, a cost compensation arrangement that deals with adverse selection and moral hazard through truthful revelation given the regulator’s information structure; and two, a separate price structure that deals with allocational efficiency. In many practical cases, it is difficult to separate these given the inherent tradeoff discussed in the incentive pricing dichotomy.A successful incentive regulation mechanism is expected to provide more powerful incentives for regulated firms to reduce cost, improve quality, stimulate the introduction of new products, and spark efficient pricing. It must be recognized, though, as acknowledged in Joskow that “incentive regulation in practice is considerably more complicated than incentive regulation in theory,” which is why direct applicability of the dichotomy is limited. Nonetheless, it is not without merit since it can provide regulators with a framework against which it can structure and evaluate its contracts.

Schmalensee (1989), as cited by Gasmi, Ivaldi & Laffont (1994), found through simulation studies that when there is little to no uncertainty about costs, price-cap regimes are often optimal. This makes intuitive sense, since when a firm’s cost function is observable, the regulator is able to set the welfare-maximizing price that drives away deadweight losses.In the 1980s, price-caps were first widely used in the United Kingdom (UK) as an alternative regulatory rule for limiting the abuse of market power. It began its widespread popularity as a response to the weaknesses of the traditional rate-of-return regulation in terms of providing incentives for cost efficiency and doing away with the complexities imposed by arbitrary cost allocations. Indeed, imposing on firms a maximum price that it can impose, firm managers, assuming their interests perfectly coincide with the interest of the regulated firms, are provided the incentive to drive down costs by improving production efficiency and eliminating wasteful spending, in the interest of keeping more profits. As a thought exercise, we can consider a government contract for the provision of water that allows a price ceiling of Php2.00 per cubic meter (m3). Suppose demand for water is 1,000,000 m3, firms can then expect a total revenue of Php2,000,000 assuming it charges maximum price. If currently, the firm can provide water at Php1,500,000, then it can still take profits of Php500,000. If managers are able to drive costs down to Php1,000,000 by minimizing water leakage, then it will derive Php500,000 more profits that will entirely accrue to the firm, an incentive the regulated firms get for added production efficiency that potentially reduces the relative deadweight loss in the society in favor of added producer surplus. Further to this, in a 1983 report by Stephen Littlechild, it is stressed that a price-cap regulation reduces the information burden of regulation through the elimination of arbitrary measures of a return on capital and cost allocation. While this is true for information on a firm’s cost structure and efficiency type, this does not eliminate information requirements on the consumer’s preference structure and willingness to pay in order to establish a welfare-maximizing price.

Although outside the direct and explicit scope of the incentive-pricing dichotomy, a price-cap regulation is also often critiqued for the absence of a provision for quality. While it is undisputable that a price-cap mechanism provides large incentives for cost minimization, this may be done at the expense of product and/or service quality. The welfare effects of substandard quality of products may find its way into the supply chain, thus also affecting the cost efficiency of non-regulated and/or competitive firms. As Joskow cites, the “performance of the regulated segments can have important effects on the performance of the competitive segments when the regulated segments provide the infrastructure platform upon which the competitive segments rely (e.g., the electric transmission and distribution networks).” Therefore, even when price-cap regulation is successful in providing incentives for cost efficient production that reduces the society’s deadweight losses from the regulated firm, its overall welfare consequences extend to intermediate industries that highly rely on the regulated firm’s products. In this case, it is important to ask the question of whether the benefit from the decrease in deadweight losses from the regulated industry is worth the increase in marginal costs, and consequently, prices, in non-regulated and/or competitive industries.

Price-Cap Regulation with Downward Price Flexibility

A pure price-cap mechanism, as previously discussed, may be most appropriate given complete lack of cost observability, i.e., both ex-ante and ex-post; however, having some knowledge of a firm’s cost structure, either ex-ante or ex-post, or both, allows regulators to design an incentive regulation mechanism that permits consumers to share in the surplus derived from cost-saving initiatives pursued by regulated firms. Although a utilitarian regulator is indifferent on which agent benefits from the social surplus, other types of social welfare function that gives more weight to consumer welfare may find this type of price-cap regulation much more desirable.

King (1998) sets the standard price-cap regulation in the UK called the RPI-X cap and in Australia called the CPI-X cap as base examples of a price-cap regulation with downward price flexibility, where RPI and CPI is based on the main index of commodity prices and X is meant to reflect potential cost savings by the firm due to either increased efficiency or technological progress. It is the X-factor that allows cost savings to be shared with consumers without adversely affecting the incentives of the firm to minimize costs in between review periods; which is in contrast to a profit regulation where any benefit from cost reduction is shifted immediately to consumers, thus destroying any cost minimization incentives. Therefore, X-factors must be set to reflect expected firm productivity improvements and expected changes in input prices for the regulated firm, while relying on historic information about the performance of the regulated firm and other firms in similar industries, since if re-evaluation is based on current firm performance, then the regulator subjects the mechanism to potential abuse by the regulated firm through cost manipulation, for instance, which leads to a cost accounting nightmare worse than a cost-based regulation. In fact, King (1998) suggests that the information used in the regulatory review should be beyond that control of the regulated firm.

A price-cap regulation with downward price flexibility addresses the criticism that a pure price-cap regulation provides too large a rent to regulated firms. It can be argued that such rent is justifiable on grounds of attaining higher production efficiency; but allowing downward price flexibility can potentially lead the society closer to allocative efficiency, that is, marginal cost pricing. Nonetheless, since the rents derived by the regulated firm under a pure price-cap regime come from higher prices (although lower than being not regulated at all) and not from socially costly transfers, the marginal social benefit of a price-cap with downward price flexibility just comes from reduced deadweight losses and/or a transfer of surplus from the producer to the consumer. At some point, the regulated firm will find little incentive to minimize its costs since it still must generate enough revenue to cover its fixed costs. Therefore, with downward price flexibility, there still exists a trade-off between providing incentives to reduce costs and the desire by regulators to pass on any cost savings to customers.

Moreover, since prices will not tend to move as low as the firm’s marginal costs, having some information about the cost function and the technological landscape of the regulated industry may not necessarily bring the society to allocative efficiency. Instead, it can only allow prices as low as Ramsey-Boiteux prices, i.e., inverse-elasticity prices. This is consistent with the tradeoff described in the incentive-pricing dichotomy; that is, achieving allocative efficiency would entail the society to provide the regulated firm some socially costly rent that will give the firm the incentive to reveal its type and to minimize costs.

Price-Cap Regulation with Revenue Sharing Mechanisms

Another variant of price-cap regulation that mandates the regulated firm to share its cost savings to consumers is one with sharing mechanisms. For purposes of this paper, only revenue sharing mechanisms is discussed, although there also exists a sharing mechanism based on earnings. Strofollini (2002) points out that a limitation of price-cap regulation with downward price flexibility is its weak incentives for information acquisition since prices cannot fully adjust upwards. To put this simply, suppose costs increase due to exogenous factors, since prices cannot increase in between review periods, firms are not keen on learning about its own cost structure since it does not gain anything from knowing about it. With little knowledge about cost structure, there is less room for innovation and product expansion. As Iossa & Strofollini puts it, “profitable and socially optimal price reduction will be forgone when technological conditions improve.” This is in contrast to Laffont (1994), where it is assumed that the regulated firm is already fully knowledgeable of its cost structure; hence, given the right incentives, it is automatically able to fully internalize its technological environment and pursue cost minimizing and product innovating initiatives.

A price-cap regulation with revenue sharing mechanisms requires a fraction of revenues to be rebated to consumers, either through discounts or lumpsum transfers. Alternatively, it may also be viewed as a price-cap regulation with taxation of revenue, where the tax is given back to the society as a transfer from the regulated firm either directly to the consumers or through the regulator to form part of public funds. Iossa & Strofollini (2003) argues that this mechanism increases the regulated firm’s incentives to acquire information about its own cost structure. Since the revenues retained by the firm decreases in whatever price it chooses, its profits become highly sensitive to exogenous changes in costs, thus raising the value of information to firms. In effect, a price-cap regulation with revenue sharing mechanisms more effectively promotes cost minimization and product innovation within regulated firms compared to a price-cap regulation with downward price flexibility. With more knowledge about the technological environment, costs will be lower and so will be prices, thus lower deadweight losses and higher social welfare, a benefit that is far more vital than resource redistribution to consumers.

Social Cost of Transfers

Different types of price-cap regulations may address the need for a price structure that brings the society closer to allocative efficiency; but, as Laffont (1994) suggests, a compensation scheme that will address adverse selection and moral hazard issues is also needed. Transfers from the regulator to the regulated firm serve as rents that reveal to the regulator the efficiency type of firms, thus allowing the regulator to impose the proper price and cost minimization regulations against the firm to be regulated. However, since transfers are socially costly, it must be met with the potential benefits it affords the society.

The social cost of transfer, is treated as an exogenous parameter in Laffont (1994). Although beyond the scheme of regulation, balancing the social cost of informational rent with its benefits may also be met by reducing the social cost of transfers. Gasmi, Laffont & Sharkey (1999) expectsto be higher for economies with less efficient tax systems. Thus, one way to enhance tax efficiency is by imposing taxes on inelastic goods such that the deadweight loss to society caused by distortionary taxation is smaller, pursuant to theories of optimal taxation. With this, matching transfers with the imposition of efficient taxes will narrow down the gap between the social cost of public funds and the benefits from allocative efficiency.

Conclusion

Managing the social cost of the formation of natural monopolies requires a two-fold regulation based on Laffont (1994) incentive pricing dichotomy. An incentive regulation mechanism that considers this requires a cost compensation arrangement that deals with adverse selection and moral hazard and a price structure that deals with allocational efficiency.

A price-cap regulation is one way of setting up a separate price structure that will allow the society to be closer to allocational efficiency. When consumers’ preferences are known such that the regulator is able to determine their willingness to pay, then a pure price cap regulation may be sufficient. A pure price-cap regulation relieves the regulator from informational burden on the firm’s efficiency and cost structure, while, at the same time, it pushes the firm to pursue cost minimizing initiatives.

As an extension, a price-cap regulation may also include a provision for downward price flexibility or a provision for sharing mechanisms, which is a way for the regulator to allow consumers to share from the rents derived from cost savings. As discussed, this is not without a tradeoff since at some point, the regulated firm will find little incentive to minimize costs further since the total revenue that accrues to the firm will not cover the firm’s total cost. However, in the absence of the assumption that firms are fully knowledgeable of their cost structure, a price-cap regulation with sharing mechanisms is argued to more effectively promote cost minimization and product innovation initiatives since it gives the regulated firm an incentive to acquire information about its cost structure and technological environment in order to raise its profits (net of the revenue shared to consumers). It must be noted though that in the absence of key performance indicators that require a regulated firm to provide quality products and services, cost minimization may be exploited at the expense of quality, which may affect the marginal costs of competitive firms. Therefore, the overall welfare consequence of a successful price-cap regulation extends to its effect on intermediate industries that highly rely on the regulated firm’s products.

A cost compensation arrangement is achieved through transfers from the regulator to the regulated firm. While the cost of these transfers is equivalent to the social cost of public funds, , which is treated as an exogenous parameter in Laffont (1994), it still is arguable that it is not beyond the control of policymakers sincecan be made lower by implementing an efficient tax system.The success of an incentive regulation mechanism highly depends on its sound implementation. Joskow (2014) enumerates the vital roles of information gathering, auditing, and accounting institutions “for developing sound approaches to the treatment of capital expenditures, to develop benchmarks for operating costs, to implement resets of prices, to take service quality attributes into account, and to deter gaming of incentive regulation mechanisms that have mechanisms for resetting prices over time.” In other words, the fact that cost and quality are usually observable ex-post must be considered in determining the optimal menu of contracts that the regulator offers to firms.