Reading: Competition Policy: Price Regulation

Business Management for Every Enterprise

Unit 6

Competition Policy: Price Regulation

Price Intervention

Not all prices are set by free-market forces of supply and demand.

In the U.S., Britain, and EU, a number of prices are affected by regulators who may impose regulations of supplier in different industries.

Good examples are rail fares, the cost of postage stamps, and water bills.

In the UK rail industry, some fares are unregulated allowing the train operating companies to set their own prices.

But around half of the fares charged for rail travelers are set by the rail regulators. 

Price Capping

Price capping is an alternative to rate of return regulation, in which utility businesses are allowed to achieve a given rate of profit on capital.

In the UK, price capping has been known as “RPI-X”. This take the rate of inflation and subtracts expected efficiency savings X. So for example, if inflation is 5% and is X is 3% then an industry can raise prices on average by only 2%.

In the water industry, the formula is “RPI-X+K”, where K is based on capital investment requirements designed to improve water quality and meet EU water quality standards. 

The UK recently introduced a price cap on pay day loan interest rates. 

UK Rail Fares

Arguments for Price Capping

Capping is an appropriate way to curtail the monopoly power of “natural monopolies” or dominant firms thereby preventing them from making excess profits at the expense of consumers.

Cuts in the real price levels are good for household and industrial consumers leading to an increase in consumer surplus and higher real living standards in the long run.

Price capping can help to stimulate improvements in productive efficiency because lower unit costs are then needed to increase a producer’s profits.

The price capping system can be a tool for controlling consumer price inflation in the UK although inflation has been below the 2% target in the UK in recent years. 

Arguments against Price Capping

Price caps have led to large numbers of job losses in the utility industries.

Setting different price capping regimes for each industry distorts the working of the price mechanism.

The industry regulator may not have enough accurate information when setting the price caps for future years – this can lead to regulatory failure.

Capping prices means lower profits which in turn can lead to reduced capital investment by the utility businesses – ultimately consumers suffer if there is under-investment in utility infrastructure because this limits supply. 

Unintended Effects of Price Capping

Price Capping – High Prices – High Profits

Impact of Price Capping on a Market

Overview of Price Capping on a Market