It is claimed that an advantage of price regulation is that it does not affect decisions about which production process to use, and that fewer problems of implementation and enforcement are encountered. The conventional analysis is summarized in Figure 3.4. An unregulated and profit maximizing natural monopolist produces output q* and sells at price p*. If a regulated price of p’ is imposed, the monopolist's marginal revenue schedule is affected. Given that the monopolist can sell extra units of output up to the amount q’ at the regulated price p’, marginal revenue over this range of output is simply given by the imposed maximum price. Further increases in output beyond q’ will require that price falls below p’, and marginal revenue will then follow the original curve labelled MR. The full marginal revenue curve of the price constrained monopolist is therefore given by the discontinuous line p’abMR. A regulated profit maximizing monopolist will therefore produce output q’. Up to q’ marginal revenue under regulation exceeds marginal cost. Beyond q’ marginal cost exceeds regulated marginal revenue.
Figure 3.4 The efficiency gain from price regulation
Regulation has resulted in a gain to consumers of the area p*eap’ through the fall in price and increase in output. Geometrically this is equal to the area eabd. (The original marginal revenue curve shows the extra payment made by consumers for an additional unit of output, i.e. allowing for the fact that price is falling, while the demand curve shows the maximum that they would have been prepared to pay. Thus the vertical distance between the two curves is the gain to consumers of an extra unit of consumption.) The profits of the monopolist have fallen by area bed (the difference between marginal cost and marginal revenue). Thus the gain to consumers minus the loss to producers is represented by the shaded area eacd. These changes have occurred apparently without the effects on input decisions involved with rate of return regulation. The terms upon which the various inputs may be used are not influenced by a regime of simple price control, and a profit maximizing but regulated firm will operate with the same cost curves as an unregulated one.
Closer attention to the relationship between regulator and regulated suggests that this analysis is seriously incomplete. The most obvious point is that the regulator will need some criterion upon which to base a choice of regulated price. In Figure 3.4, for example, a regulator pursuing consumer interests might be aiming to achieve an average cost price on the grounds that this is the minimum price achievable given that the monopolist cannot make losses. Linking prices to costs in this way, however, creates bargaining problems similar to those encountered with rate of return regulation. Regulators will not have the detailed knowledge of cost conditions that is available to the firm. If the firm appreciates that the regulated price will be influenced by its own cost estimates, it will have an incentive to distort upwards its projections of future costs. Further, if it expects all cost increases to be reflected in adjustments to the regulated price, the firm will not have the incentive to be technically efficient. In the absence of potential competition and with a cost-based form of price control, the environment would be conducive to the ‘hiding’ of profit as costs.
Another basic problem with price regulation is that it involves specifying the unit of output whose price is subject to regulation. Not only will a monopolist often be supplying a whole range of services or goods, but these may all be subject to potential quality variations. To prevent a monopolist responding to regulation by skimping on quality, regulatory standards are required to supplement simple price control. The cost of negotiating and policing such standards for every separate service supplied by the monopolist may lead to attempts to simplify by controlling a price index of a basket of the outputs produced, and by defining quality standards rather vaguely. This then allows the monopolist some scope to change the relative prices of items within the basket (sometimes called tariff-rebalancing) and gives total freedom in pricing items outside the basket.
The Littlechild Report, The Regulation of British Telecommunications' Profitability(Littlechild 1983), proposed that the privatized British Telecom should face a system of price control to be enforced by the Office of Telecommunications (OFTEL). The formula finally adopted after the sale of British Telecom shares in November 1984, requires the company, under the terms of its licence, to limit its price increases to a level of 3 per cent below the rate of increase of the retail price index (RPI). It was argued that this RPI – 3 formula would protect the consumer from monopolistic exploitation whilst giving incentives to the company to look for cost-reducing improvements in its activities. The price control scheme refers to a ‘basket’ of services within which some ‘rebalancing’ is permitted.
The scheme has been criticized on the grounds that the necessity of periodic renegotiation will effectively turn it into a regime of rate of return regulation. How would the new value of ‘X’ be fixed in 1989? If it simply took account of the productivity improvements actually achieved by British Telecom, it would undermine the future incentives to pursue such improvements. On the other hand it is not clear upon what other grounds a suitable figure could be imposed. Ideally the figure should reflect the cost improvements potentially achievable by an efficient company, but to assume that a regulatory body could be in possession of information of this order would be totally unrealistic.
In the event, the formulae arrived at have been as follows: 1984–89, RPI – 3; 1989–91, RPI – 4.5; 1991–93, RPI – 6.25; 1993–97, RPI – 7.5; 1997–2000, RPI –4.5. Since 1989 the value for ‘X’ has been reviewed at two-year intervals.
