Regulation in Practice.

what are the two ways in which firms are regulated in pratice?

cost of service regulation + price cap regulation

where does the regulator set the price at for cost of service regulation?

price = AC, firms break even.

what are the strengths of Cost of Service Regulation?

• firms stay solvent.

• protects consumers from excessive pricing.

• reduces risk for firms as rules are stable and predictable.

what are the weaknesses surrounding Cost of Service Regulation?

• firms are reimbursed for costs, and therefore there is no reward for efficiency.

• incentive to over invst in capital because returns are earnt on rate base. leads to excessive capital/labour ratio. firms prices are increased to cover the increasing costs.

• firms may exaggerate costs to get higher prices.

how can regulators stop the Averch Johnson effect occurring?

• prudence reviews are used to examine whether capital investment is efficient and effective.

• short lag reducing the time that firms can continue to make high profits.

what must regulators balance?

• efficiency and cost minimisation.

• fair prices for consumers.

• financial stability for firms.

what process is taken for price-cap regulation?

• regulator sets a maximum price which the firm can charge for 4-5 years.

why does the price-cap work well?

• if firms reduce their costs, it keeps the profits until the next review.

• less need for each year regulator needing to know costs.

• simpler and transparent.

what are the problems associated with price-caps?

• bargaining costs of arguing over cost projections.

• firms may cut quality to reduce costs.

• if X is too high then firm will be underfunded and won’t make back the money.

• if X is too low then firms will be able to make excessive profits.