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Perhaps the most plausible option for the regulator is point F; that is, to set the price where AC crosses the demand curve at an output of 6 and a price of 6.5. This plan makes some sense at an intuitive level: let the natural monopoly charge enough to cover its average costs and earn a normal rate of profit, so that it can continue operating, but prevent the firm from raising prices and earning abnormally high monopoly profits, as it would at the monopoly choice A. Of course, determining this level of output and price with the political pressures, time constraints, and limited information of the real world is much harder than identifying the point on a graph. For more on the problems that can arise from a centrally determined price, see the discussion of price floors and price ceilings in Demand and Supply .

Cost-plus versus price cap regulation

Indeed, regulators of public utilities for many decades followed the general approach of attempting to choose a point like F in [link] . They calculated the average cost of production for the water or electricity companies, added in an amount for the normal rate of profit the firm should expect to earn, and set the price for consumers accordingly. This method was known as cost-plus regulation    .

Cost-plus regulation raises difficulties of its own. If producers are reimbursed for their costs, plus a bit more, then at a minimum, producers have less reason to be concerned with high costs—because they can just pass them along in higher prices. Worse, firms under cost-plus regulation even have an incentive to generate high costs by building huge factories or employing lots of staff, because what they can charge is linked to the costs they incur.

Thus, in the 1980s and 1990s, some regulators of public utilities began to use price cap regulation    , where the regulator sets a price that the firm can charge over the next few years. A common pattern was to require a price that declined slightly over time. If the firm can find ways of reducing its costs more quickly than the price caps, it can make a high level of profits. However, if the firm cannot keep up with the price caps or suffers bad luck in the market, it may suffer losses. A few years down the road, the regulators will then set a new series of price caps based on the firm’s performance.

Price cap regulation requires delicacy. It will not work if the price regulators set the price cap unrealistically low. It may not work if the market changes dramatically so that the firm is doomed to incurring losses no matter what it does—say, if energy prices rise dramatically on world markets, then the company selling natural gas or heating oil to homes may not be able to meet price caps that seemed reasonable a year or two ago. But if the regulators compare the prices with producers of the same good in other areas, they can, in effect, pressure a natural monopoly in one area to compete with the prices being charged in other areas. Moreover, the possibility of earning greater profits or experiencing losses—instead of having an average rate of profit locked in every year by cost-plus regulation—can provide the natural monopoly with incentives for efficiency and innovation.

With natural monopoly, market competition is unlikely to take root, so if consumers are not to suffer the high prices and restricted output of an unrestricted monopoly, government regulation will need to play a role. In attempting to design a system of price cap regulation with flexibility and incentive, government regulators do not have an easy task.

Key concepts and summary

In the case of a natural monopoly, market competition will not work well and so, rather than allowing an unregulated monopoly to raise price and reduce output, the government may wish to regulate price and/or output. Common examples of regulation are public utilities, the regulated firms that often provide electricity and water service.

Cost-plus regulation refers to government regulation of a firm which sets the price that a firm can charge over a period of time by looking at the firm’s accounting costs and then adding a normal rate of profit. Price cap regulation refers to government regulation of a firm where the government sets a price level several years in advance. In this case, the firm can either make high profits if it manages to produce at lower costs or sell a higher quantity than expected or suffer low profits or losses if costs are high or it sells less than expected.

Problems

Use [link] to answer the following questions.

If the transit system was allowed to operate as an unregulated monopoly, what output would it supply and what price would it charge?

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If the transit system was regulated to operate with no subsidy (i.e., at zero economic profit), what approximate output would it supply and what approximate price would it charge?

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If the transit system was regulated to provide the most allocatively efficient quantity of output, what output would it supply and what price would it charge? What subsidy would be necessary to insure this efficient provision of transit services?

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Questions & Answers

what is supply
Mizta Reply
what is opportunity cost
Mizta
The opportunity gained interms of opportunity lost is known as opportunity cost Or The second best alternative use of resources
Mir
forgone alternative: like forgoing Something our of two to buy one
Tam-Waribo
what is macro economic s
Addo Reply
macroeconomics is the study of economic as a whole level.
Gafar
meaning of positive science
Sumit Reply
positive science it is focused on facts and cause and effect and behavioural relationship and include developmental testing in economic theoreis.
Gafar
what is inflation
Sama Reply
inflation is the general price increase of goods and services in an economy.
tesfie
Inflation is the persistent rise in the general price level
T-Max
inflation is characterized by increase in the general price of goods and services. when there is too much money in circulation. increase in demand of goods pursuing fewer goods. when purchasing power of money decreases .
Ejikeme
inflation is the persistent rise general price level
Habeeb
inflation is the persistent increase in price
Machall
hi
Rafiu
yes
boston
hi
Ayaan
how are you
Ayaan
increase in the general level of price...
sade
what is deflation
Sele
is the gradual decrease of currency exchange in a country.
Gafar
different between demand and quantity demand
Farhan Reply
No difference
MansoorAfghan
demand is the overall demand for it
MansoorAfghan
actually theres no difference
MansoorAfghan
quantity demanded is used in Equilibrium of d and s
MansoorAfghan
for evrything else u use deman
MansoorAfghan
the difference of it is that when demand simply denotes the willingness and a person's ability to purchase. And as against quantity demand represent the amount of an economic good or services desire by a consumer at a fixed price .☺
Gafar
how to calculate inflation
Richard Reply
Explain the factors that have led to high quantity demanded
Ogwang Reply
price of the product increase of price substitute product as people shift to cheap one
Black
what are the methods used by trade union to increase wages of their members?
Black Reply
strike
Pearl
the size of the commodity
Mensah
increase demand of labour decrease supply of labour
Black
I do support your answer Jackel.
keshav
but how do they do it?
Black
by increasing more labour and reduced the suppliers
Mensah
they can not increase labour, they increase demand of labour.
Black
how do they increase demand for labor?
Black
by analyzing the market equilibrium , cost reduction and cost control , savings in time .
yash
decreasing supply of labour are achieved through training and certification that require for you to employed, you must have certificate, also trade union encouraged government to restrict migration into the country causing shortage of labour supply. Note that the aim of union is to enhance life
Black
objective of union: better working conditions, liveable wage, protect member from unfair treatment which are done through negotiations betweens representative and management. known as collective bargaining.
Black
what is the nature of economics?
Tyscar Reply
economics is a social science since it seeks to solve social problem of scarcity
Jamal
main concerns is the decision individuals make on the allocation of scarce resources among the competing wants
Black
in the short run firm produce a positive as long as the price is larger than what?
yoel Reply
what is economic
Bah Reply
economics is the study of managing the resources in order to maximize the needs and satisfy the wants to a great extent in a regulated set-up..
Muhammad
One explanation for deviation when there is no impact on balance of trade
Shaneel
economic s is a social science that deals with human behavior as a relationship between ends and scarce means which has alternative uses
Derokiz
economic is a study of mankind in ordinary business of life
FIDELIS
economics it is the study of social science that deals with human behaviour as relationship between ends and scarce means which have alternative uses
salam
Economic is the use of scarce recourses to attain economic dough effectively and efficiently.
Addo
economics is the study of how humans make decisions in the face of scarcity. Eg. family decision, individual decision, and societal decision.
Gafar
what is diminishing returns
Blessed Reply
what is the difference between calculus linear equation and derivative?
Bti
whats inferior goods?
jaamac Reply
Good having low quality , also known as giffin goods. When income increases people shift to better quality goods . Hence having a negative effect on inferior goods rather than positive relation ( ie when income increases demand increases but not in case of inferior goods ) example wheat and bajra .
yash
What do u understand by the word ENDS in professor Lord L C Robinson definition of Economics?
Kaba Reply
I understand that ENDS is the unlimited needs of human. But we have limited resources to achieve our unlimited needs/wants. Thank you.
Midhun
variable is a factor that can change
nyodb Reply
did you understand definition of variablE
nyodb

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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