Monopoly Regulation, Chilean Style: The Efficient-Firm Standard in Theory and Practice

CEA Working Paper No. 180

36 Pages Posted: 7 Mar 2004

See all articles by Álvaro E. Bustos

Álvaro E. Bustos

Pontificia Universidad Catolica de Chile

Alexander Galetovic

Universidad Adolfo Ibáñez; Stanford University - The Hoover Institution on War, Revolution and Peace; University of Padua - CRIEP

Date Written: March 2004

Abstract

This paper analyses the foundations of efficient-firm regulation (implemented in Chile for almost two decades), and the formulas that are used to set the prices of water/sanitation companies, electric power distributors and the dominant phone companies. We show that efficient-firm regulation implies setting prices equal to long-run average cost, which is optimal when the firm is required to be self-financing. In contrast, this is not true of the best-known alternatives, namely regulation based on rate-of-return or a price cap. We also show that in both efficient-firm and price-cap regulation, the fixed and exogenous period that is maintained between price-setting processes stimulates productive efficiency.

We argue that the price-setting formulas and procedures used assume that the regulator has sufficiently precise information to determine the costs of a hypothetical efficient firm, without the need for information from the real firm. Nonetheless, modern regulatory theory and practice both show that prices cannot be set without drawing upon information that only the real firm possesses.

The model developed in this paper is used to discuss the potential gains from replacing efficient-firm regulation by a price cap. We conclude that price-cap regulation also requires considerable amounts of information from the real firm; so, for the time being, Chile should focus on improving regulatory procedures, rather than changing the underlying mechanism.

Keywords: Chile, depreciation, electricity, price cap, rate-of-return regulation, sustainability condition, telecoms, water

JEL Classification: L51, L94, L95, L96

Suggested Citation

Bustos, Álvaro E. and Galetovic, Alexander, Monopoly Regulation, Chilean Style: The Efficient-Firm Standard in Theory and Practice (March 2004). CEA Working Paper No. 180. Available at SSRN: https://ssrn.com/abstract=514243 or http://dx.doi.org/10.2139/ssrn.514243

Álvaro E. Bustos

Pontificia Universidad Catolica de Chile ( email )

Vicuna Mackena 4860. Macul
Santiago
Chile

HOME PAGE: http://https://sites.google.com/site/20bustos13/

Alexander Galetovic (Contact Author)

Universidad Adolfo Ibáñez ( email )

Peñalolén
Santiago
Chile

Stanford University - The Hoover Institution on War, Revolution and Peace ( email )

Stanford, CA 94305-6010
United States

University of Padua - CRIEP ( email )

Padua
Italy

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