Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Price Cap Regulation

What it is:

A price cap regulation places a ceiling on the amount companies in a given industry (typically utilities and telecommunications providers) can charge for services.

How it works (Example):

Price cap regulation typically has four tenets:

1. The regulator establishes a set of acceptable prices for the service. The regulated company can sell its services at any price that is equal to or below the price ceiling. The regulator may also set a price floor to discourage anticompetitive pricing, and it might require companies to refund excess profits.

2. The regulator may group services into baskets and set an overall price cap for them, or it might set a price cap for each individual service. When the regulator caps prices for a basket, the producer can raise the price of one item in the basket as long as it adjusts the prices of the other items in the basket to make the weighted average price equal or fall below the cap.

3. The regulator may adjust a price cap based on changes in industry prices or productivity. The strategy is to reflect the market-clearing price in competitive markets.

4. The regulator periodically reviews the price cap system. It may change the price cap formula or review the profit conditions of a firm.

Why it Matters:

Price caps depend on several variables, including (but not limited to) efficiency, inflation, and underlying costs, but the idea behind price cap regulation is to protect consumers from price increases and protect utility providers from losses.

The idea is to weaken the relationship between the costs of production and the prices of products and services, but from a financial perspective this can often send mixed messages to managers. For example, because a firm is typically allowed to keep any profits obtained via cost reductions relative to the price cap, in theory price cap regulation increases efficiency. (This differs from traditional regulation, in which the regulator typically allows price increases based on cost increases.) However, a classic criticism of price caps is that this very incentive actually encourages companies to degrade the quality of service in an effort to cut costs.