Consider for example, a regulated monopoly which is not permitted to earn more than a given rate of return on capital. A policy of this kind would give the firm an incentive to adopt processes of production which were relatively capital intensive. The situation is illustrated in Figure 3.3. The upper part of the diagram shows the monopolist minimizing costs for a given level of output by using the combination of labour and capital at Θ. Suppose that the monopolist's profit at this point is πm and that the output level is the one the monopolist would choose if there were no regulatory constraint. Clearly the production of qm using any alternative factor combinations would involve higher costs and lower profits. If the firm operated at point e on the isoquant, for example, costs would be higher as shown by the iso-cost line cd. The lower quadrant of the diagram plots the profit of the firm for the given output level qm but using different inputs of capital and labour. As K increases above or falls below Km, profits decline (note that profits are measured from the origin and get bigger as we move down the axis).
Figure 3.3 The effect of rate of return regulation
We now impose the regulatory constraint. This is represented by the straight line through the origin labelled πR. Because the rate of return on capital is controlled, the total profit the monopolist is permitted to keep will be directly related to the amount of capital employed. The best the firm can now do is to operate at the point where the constraint intersects with the profit curve (point f). This will involve factor inputs of Lr<Lm and Kr>Km respectively and lower profits (πr<πm). Clearly the more substitutable are labour and capital in the process of production (the less curved are the isoquants), the smaller will be the absolute effect of rate of return regulation on the profits of the enterprise. Regulation would in these circumstances influence production methods rather than monopoly profits.
Even with limited possibilities for factor substitution, regulation will influence other aspects of the firm's behaviour. In the first place there is always the possibility of using capital wastefully, i.e. to no technical effect whatever. This will benefit the firm if the return on its existing capital stock exceeds the regulated level. Rather than accept price reductions, it will be preferable to increase capital inputs and retain any ‘super regulatory profits’ in the form of a return equal to the regulated rate on extra (though technically superfluous) capital. This possibility suggests that a regulatory agency will require considerable technical knowledge of an industry's production function and the power to supervise production methods, if it is to prevent the capital base of companies rising in response to rate of return regulation. Designing a regulatory institution capable of receiving and processing relevant information and with the required incentives to use it efficiently would seem a considerable problem. Assuming a solution is found, however, the agency is inevitably led further to interfere not merely in production methods but also in the determination of output.
Even in the case of a firm whose production processes allow of no factor substitution and which faces a well-informed agency capable of preventing the use of ‘fraudulent’ capital there will be other possible responses to regulation. The firm will have the option of increasing its output level. Although this will reduce the price that the firm can charge and reduce its gross profits, by adding to the use of capital, the firm is again enabled to keep more of the profit which accrues to its operations.
The general problem with regulatory systems which attempt to control rates of return is that perverse incentives are created, and a complex bargaining situation develops. Firms will have incentives to mislead regulators about the size of the ‘rate base’, to press for a suitably favourable definition of the base, to conceal information about the role and productivity of items of capital equipment and so forth. Regulators, recognizing the monitoring costs that they face and anticipating strategic behaviour on the part of firms, will be induced to respond strategically themselves, for example by threatening to reduce the allowable rate of return. Alternatively, the continuous negotiations between regulator and regulated may lead to regulatory ‘capture’. If regulators find information costly to acquire, so also will the politicians to whom they are responsible. A principal-agent relationship can be seen as characterizing the association between politician and regulator, and the interests of the latter may, in the long run, have more in common with the regulated industry than with government ministers. The bargaining costs associated with this form of regulation, and the possibility that input decisions will be affected, have led to the search for alternatives. The next section discusses one of these alternatives, price regulation
