Regulation, regulators and price caps

Overview

Regulation as an instrument of competition policy, role and purpose of a regulator and regulators used in industries such as water.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is regulation as an instrument of competition policy?

   Model answer

   Regulation is the imposition of rules on how firms in a market may behave, backed by a body with power to monitor compliance and impose penalties. Typical rules cover the maximum price that may be charged, the quality and reliability of service, the information that must be given to customers, the terms on which competitors must be granted access to a network, and the conditions for entering the industry at all.

2. 2

   What is the role and purpose of a regulator?

   Model answer

   A regulator exists to produce, by rule, the outcomes that competition would have produced in a market where competition cannot be relied on. Its purposes are to prevent excessive prices, to maintain the quality and safety of the service, to protect customers who have no alternative supplier, to ensure that competitors can gain fair access to any essential network, and to secure the long-term investment that consumers will need in future.

3. 3

   Why are regulators used in industries such as water, energy networks and rail infrastructure in particular?

   Model answer

   These industries depend on a single physical network whose duplication would be enormously wasteful, so the supplier is a natural monopoly and customers have no realistic alternative. Demand for the service is a necessity with few substitutes, so the harm from unrestrained pricing would be large and would fall hardest on the poorest. Since competition cannot be created within the network, a regulator is used to impose the discipline that rivalry would otherwise supply.

4. 4

   Why does a regulator set standards for service quality as well as limits on price?

   Model answer

   A firm told only to reduce its price can meet the requirement by cutting the quality of what it supplies, reducing maintenance, slowing repairs or thinning its staffing, which leaves customers worse off in a way the price cap does not capture. Quality standards close that escape route, so the two instruments have to be used together.

5. 5

   What is a price cap, and how does it differ from setting the price directly?

   Model answer

   A price cap sets a ceiling on the price, or on the average price of a basket of services, and allows the firm to charge anything up to it. Setting the price directly fixes the figure. The cap leaves the firm free to charge less and to keep any profit from cutting its costs below the capped level, which preserves an incentive to become more efficient that a directly fixed price does not.

6. 6

   Explain the principle behind a price cap that requires prices to rise by less than inflation.

   Model answer

   The cap allows the firm to raise its prices each year by the rate of general inflation minus a set percentage, so prices fall in real terms by that percentage. The subtracted figure represents the efficiency improvement the regulator judges the firm should be able to make. Because the firm keeps whatever it saves beyond that figure until the cap is next reset, it has a strong incentive to cut costs faster than required, and consumers receive the assumed saving with certainty.

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