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Price Caps, Rate of Return Constraints and Universal Service Obligations

Price Caps, Rate of Return Constraints and Universal Service Obligations . Written By: Pio Baake. Introduction. Price Cap Regulation (PCR) Proponents of PCR argue: Easily implemented Informational requirements are fairly low Implies cost minimization behavior by the regulated firm

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Price Caps, Rate of Return Constraints and Universal Service Obligations

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  1. Price Caps, Rate of Return Constraints and Universal Service Obligations Written By: PioBaake

  2. Introduction • Price Cap Regulation (PCR) • Proponents of PCR argue: • Easily implemented • Informational requirements are fairly low • Implies cost minimization behavior by the regulated firm • Can be improved by using price caps which are explicitly based on the firm’s costs

  3. Introduction • Opponents of PCR argue: • Induces regulated monopolist to reduce service quality • Firms serve only the classes of customers with the highest willingness to pay • Firms engage in strategic price discrimination with respect to potential competitors

  4. PC/RORR Characteristics • Balances opposing incentive effects • Under PCR: • Firm tends to serve relatively few consumers and to provide a marginal tariff which entails large quantity discounts • Under RORR (rate of return regulation): • Induces firm to overinvest in its network but not to deviate from optimal price discrimination

  5. PC/RORR Characteristics • Under PCR + RORR= (PC/RORR): • Leads the firm to expand its network and to choose a marginal tariff which is more closely related to the second best tariff • But, given network size and constant profits: • Positive welfare effects due to change in firm’s marginal tariff are dominated by the negative effects due to overcapitalization

  6. PC/RORR Characteristics • Relates the allowed revenue to the firm’s costs • Capital used • Induces deviations from cost minimizing behavior • Overcapitalization • Induces the firm to expand its network • Reduces pricing distortions under PCR • Can increase aggregate welfare compared to PCR • Firms earn higher profits

  7. PCR/USO Characteristics • Forces the firm to serve a minimum number of customers • Reduces pricing distortions under PCR • Aggregate welfare is higher under PCR/USO (universal service obligation) • Overcapitalization not a problem • Firm maintains cost minimization • Firm’s revenues not as high as PC/RORR • Does not induce firm to increase its costs by using more capital

  8. Conclusion • PCR implies pricing distortions when a regulated monopolist can use non-linear tariffs. • PCR/RORR can increase aggregate welfare • Overcapitalization • PCR/USO welfare superior given number of customers and profits under PCR /RORR

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