Price Regulation and the Hope Standard

Abstract

The superior incentive properties of price cap regulation (PCR) derive from breaking the link between revenues and costs which renders the regulated firm the residual claimant for its efficiency gains. Under the Hope standard, regulated firms are constitutionally protected against confiscatory rates. This is a two-edged sword. Regulated firms may be shielded against unduly low rates, but they are also exposed to various forms of regulatory opportunism that may be used to expropriate returns above the minimum required to satisfy Hope. To wit, regulators can employ entry accommodation to reestablish the linkage between the regulated firm’s revenues and costs so that it is no longer the residual claimant for its efficiency gains. In this setting, the conclusions of the literature are reversed: investment in cost-reducing effort and profits are both higher under PCR with earnings sharing than under pure PCR. In fact, under pure PCR the regulated firm’s expected investment in cost-reducing effort and profits are both zero.

Keywords: price cap regulation, efficiency, regulatory takings, accommodative entry

JEL Classification: L51, L96