(Reprinted from HKCER Letters, Vol. 12, January 1992) 


Regulating Monopolies in Utilities
and Telecommunications by Price Cap

Pak-Wai Liu



In March 1991, the Scheme of Control for Hong Kong Telephone Company expired. The company is currently negotiating with the Hong Kong government on a new Scheme of Control based on price-cap regulation. This is a departure from existing Schemes of Control in Hong Kong which are premised on rate-of-return (ROR) regulation.

The idea of using price ceilings as a regulatory tool has been discussed by many economists in the 1960s and 1970s. Price-cap regulation, in its detailed implementable form, was first introduced by Stephen Littlechild in Britain in 1983, and was subsequently adopted by the British government for British Telecom and other privatized monopolies. In 1987 the U.S. Federal Communications Commission took up the idea of the price cap and used it to replace ROR regulation. Price caps are now being implemented for AT&T and the regional telephone companies. They are also being discussed for other regulated monopolies such as electricity supply, gas supply, and airport management.

Interest in price-cap regulation springs from a dissatisfaction with ROR regulation. ROR regulation is based on a "cost-plus" concept. The idea is that a regulated monopoly should not be allowed to make excessive profits from its franchise but should recover its costs plus a "fair" return on its investment. The ROR regulatory regime is beset with inefficiencies arising from several sources :

1. Averch and Johnson (American Economic Review, 1962) have shown that under ROR regulation, if the permitted rate of return exceeds the cost of capital, the regulated firm will choose to employ a higher capital-labor ratio than it would under cost minimization. There is an incentive for the firm to overcapitalize to increase its asset base so as to justify a larger profit given the permitted rate of return.

2. The ROR regulation provides no incentive for the firms to minimize costs, for if they reduce costs so that their returns exceed the permitted level, prices will be reduced in step. Any surplus above the permitted returns arising from cost savings will be siphoned off to the Development Fund. Under ROR regulation, monopolies operate wastefully for the simple reason that there is no pressure for them to operate efficiently. Their returns are guaranteed even if they operate with high costs.

3. A regulatory regime is said to be dynamically efficient if it can accommodate changes and growth over time. Specifically, the regime has to encourage the regulated firms to adopt innovation and invention and to accommodate changes in taste and preference of the consumers. In the ROR regulatory regime, regulated monopolies have little incentives to adopt either cost-saving innovation or introduce innovative new products because their profits depend directly on their assets, and returns on them are guaranteed.

To summarize, the ROR regulatory regime assumes that the regulators have sufficient information on costs, demand, and technology of production in setting optimal prices. In reality, there is an asymmetry of information inherent in the relation between the regulators and the regulated monopolies. The regulated monopolies have informational superiority over the regulators in all aspects of their operation, which they can then exploit to their advantage. Consequently the regulators are seldom effective in enforcing efficiency. The informational handicap of the regulators becomes particularly severe in industries in which there are rapid technological changes. By contrast, the price-cap regulatory regime is more market- and incentive-driven and less dependent on information.

Principle of Price-Cap Regulation

The principle of price-cap regulation is to regulate the monopoly so that it will have no excess profit. All factors of production including capital will have been paid for. That means capital investment will have received its normal return. When there is no excess profit, revenue must equal total factor payments. This relation can be shown to be the same as

Rate of price increase = rate of input price increase
                                     - total factor productivity

We can approximate the rate of input price increase by the retail price index (RPI) or consumer price index (CPI). This is necessary because it is difficult to have consensus between the regulators and the regulated monopoly on input price inflation due to problems of information, whereas RPI data are generally reliable and available. The above relation can now be written as

Rate of price increase = RPI - H (1)

where H is total factor productivity and all variables are measured in units of percent per annum. Equation (1) suggests that as long as the monopoly concerned increases its price at a rate given by RPI-H, it will earn a normal return on its capital investment and there will be no excess profit. This serves as the basis for the price-cap regulatory regime which can be expressed as follows :

Price cap = RPI - H (2)

The price cap is the maximum rate of price increase permitted under the regime. If the monopoly is regulated according to formula (2), it will have no excess profit, but it will also have no incentive to increase productivity. If H is low, the price cap will be high and the regulated monopoly is entitled to raise price until it obtains a normal return on its investment.

An aim of the regulators should be to provide incentive for the monopoly to increase productivity and to have the benefits derived from it shared among the monopoly and users of its service, the rate-payers. A commonly adopted proposal is to replace H in (2) by an adjustment factor X to be determined by negotiation between the regulators and the regulated monopoly.

Price cap = RPI - X (3)

The key features of a RPI-X regulation are as follows:

1. The regulators directly set a ceiling for prices to be charged by the regulated firm according to a formula; the average price of a specified basket of services must not exceed RPI-X.
2. For a pre-specified period, the regulated firm may set prices freely below the ceilings.
3. Price ceilings are defined for baskets of services provided by the regulated firm. Different ceilings may apply to different baskets.
4. The adjustment factor X will be reviewed and possibly changed at the end of the specified period of several years.
5. The quality of service will be monitored by a regulatory agency.

Incentive for Productivity under Price-Cap Regulation

The major problem of price-cap regulation is to set an appropriate adjustment factor X so as to provide incentive for the regulated firm to improve productivity and so that consumers can share the benefits of productivity increase. If the monopoly is regulated according to (3), and X is set exogenously, the monopoly will have incentive to improve its productivity so that it grows above X.

This can be illustrated by a numerical example. Suppose RPI = 10%, X =3% and H = 4%. Then the rate of price increase that will yield no excess profit according to (1) is 6%, but the price cap under (3) is 7%. Under price-cap regulation, the monopoly is entitled to increase price by 7%, which is one percentage point above what is necessary for it to obtain a normal return on its capital investment. This differential will translate into excess profit for the monopoly. Therefore, the monopoly will have an incentive to improve productivity once X is fixed. The problem with this simple approach, however, is that the monopoly will reap all benefits of this higher productivity and not share them with the rate-payers.

A more sophisticated way of determining X is needed to induce sharing of benefits arising from higher productivity, while still maintaining the incentive for the monopoly to achieve such an increase. X has to be related to the expected rate of productivity of growth reported ex ante and the actual rate of productivity growth achieved ex post. Due to an asymmetry of information, the regulated monopoly has superior information on its cost structure and the technology of production vis-a-vis the regulator. It is in a better position to estimate and report on its expected rate of productivity growth. However, if the monopoly is left to do this, it will have a strong incentive to underreport in order to get the smallest X possible.

To solve this type of incentive compatibility problem, economists devise self-revelation mechanisms to induce truth-telling. The idea is to devise a mechanism so that the party that has the superior information will report truthfully because it is in its interest to do so. In other words, the monopoly, in maximizing its profit, will also maximize society's objective so that the incentives of both parties become compatible.

Self-revelation is common in the incentive literature and the decentralized planning literature in economics. It can be applied to the setting of X under price-cap regulation. The interest of the monopoly is to have X as low as possible, while the interest of the rate-payers is the reverse. The idea is to devise a formula so that X is smallest if the monopoly reports an expected rate of productivity increase which turns out to be realized exactly. This will induce the monopoly to report as best as it can its expected rate of productivity growth for the coming year. Parameters for the formula can also be carefully chosen so that, once the monopoly reports truthfully its expected rate of productivity growth, it will have continuing incentive to achieve as high a rate of productivity growth as possible, and that both the monopoly and the rate-payers will share the benefits. I have proposed and analyzed the properties of a possible self-revelation formula elsewhere. The analysis is rather technical and I will not repeat it here. (See "Utilities and Telecommunications: Regulation of Monopolies" in The Other Hong Kong Report, 1991, The Chinese University Press.)

Advantages of Price-Cap Regulation

The advantages of price-cap regulation are numerous. First, under price-cap regulation, the regulated firm will take the maximum price as given and seek to minimize costs and invest at levels that are efficient, given the levels of demand resulting from the ceiling prices. The regulated firm is motivated to do this because it gets to keep whatever profits it can earn (and must also absorb any loss that may emerge). The incentive for productive efficiency under unconstrained maximization is preserved. Second, since it gets to keep all profits, the regulated firm has the incentive to innovate and to introduce new products and services which will increase profits. Third, rate-payers also gain, as part of the expected increased efficiency will be passed on to them via sharing. Fourth, prices are likely to be lower than they would be under ROR regulation. As long as X is positive, the rise in price will always be slower than the general inflation rate, thus helping to slow down inflation. In fact, under price-cap regulation, the regulated firm is more willing to lower its price, since a subsequent increase in price cannot be denied as long as it stays below the ceiling. Fifth, the administrative costs of price-cap regulation are lower than that of ROR regulation, as price-cap regulation is simpler to operate by the regulators and the firm.

Price-cap regulation is particularly suited for industries which experience rapid technological changes and which are monopolized. A carefully defined price-cap formula will motivate innovation, enhance efficiency, and ensure that the rate-payers will enjoy the benefits of technological advancement. An industry that fits this description is telecommunications. Technological advances in opto-electronics have lowered the costs of international telecommunication considerably. For instance, the U.S. Federal Communications Commission estimated that the cost per minute of using a trans-Atlantic cable fell from US$2.53 in 1956 to four cents in 1988 and is expected to fall further to two cents in 1992. A price-cap regulatory regime can be designed to ensure that the benefits of this substantial cost reduction brought on by technological advances will be passed on to the rate-payers.

Dr. Pak-Wai Liu is a Reader and Chairman of the Department of Economics at The Chinese University of Hong Kong.


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