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Price-Level Regulation and its Reform

James Ming Chen

Michigan State University - College of Law

July 27, 2005

Minnesota Legal Studies Research Paper No. 05-18

Price-level, or "price-cap," regulation is a leading alternative to the traditional technique of monitoring a regulated firm's profits. In lieu of traditional restraints on the regulated firm's profitability, the price-level alternative entitles a regulated firm to conduct its business as it sees fit, provided that its prices do not rise above a certain level. This practice addresses three of the most severe defects in conventional cost-of-service regulation. First, as stated in the celebrated Averch-Johnson hypothesis, perverse incentives arise from a profit-regulated firm's ability to pass operating costs through to ratepayers and to collect a return on all putatively prudent investment. Second, regulated firms have historically shifted money between regulated and unregulated lines of business. Finally, conventional rate-of-return regulation is slow and expensive.

Price-level regulation also facilitates Ramsey pricing. In a regulated environment, the pricing methodology that minimizes the social loss from setting prices above marginal cost is one that allocates fixed costs among different products in inverse proportion to the elasticity of demand for each product. Price-level regulation overcomes administrative difficulties in Ramsey pricing by delegating cost allocation decisions to the regulated firm. Even without knowing demand elasticities, a regulator can implement Ramsey pricing by allowing the regulated firm to allocate prices among its own customers. The degree to which price-level regulation facilitates Ramsey pricing depends on the extent to which regulators eschew "sharing" mechanisms designed to capture the price-capped firm's profits for its customers' benefit. The greater the degree of sharing that regulators mandate, the lower the regulated firm's incentive to engage in Ramsey pricing.

Price-level regulation combines benchmarks of prices with fine adjustments of a regulated firm's freedom to raise prices. After regulators determine an appropriate initial price level, an effective cap requires periodic adjustments to an inflation index and to certain 'exogenous' changes outside the firm's control, coupled with a percentage offset for anticipated productivity gains. A price cap thus varies (1) upward, according to a gauge of general inflation, and (2) downward, in anticipation of the extent to which the regulated industry will experience faster productivity growth than the economy at large.

This paper examines American legal decisions involving price-level regulation. It examines the adoption of inflation indexes as well as the computation of the so-called X-factor, which purports to reduce price caps according to improvements in industrial productivity. It criticizes the mismanagement of both prongs of the price-level strategy by American regulators and judges. In particular, American price-cap schemes continue to apply inappropriate measures of price change, both in the economy at large and in specific industries.

In the two decades since its introduction in the United Kingdom, however, price-level regulation has become the dominant form of rate regulation in the United States. As of 2002, no fewer than 48 states have adopted price-level regulation as their default method for regulating incumbent local exchange companies. Not without reason is price-level regulation regarded as the mostly successful "final stage in a century of developing ratesetting methodology." Although it is unclear whether price-level regulation has provided adequate incentives for capital investment, the infusion of stronger incentives to improve efficiency renders price-level regulation a great success.

Number of Pages in PDF File: 17

Keywords: price-level regulation, price caps, inflation, consumer price index, x-factor

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Date posted: August 3, 2005  

Suggested Citation

Chen, James Ming, Price-Level Regulation and its Reform (July 27, 2005). Minnesota Legal Studies Research Paper No. 05-18. Available at SSRN: http://ssrn.com/abstract=771226 or http://dx.doi.org/10.2139/ssrn.771226

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James Ming Chen (Contact Author)
Michigan State University - College of Law ( email )
318 Law College Building
East Lansing, MI 48824-1300
United States
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