Rate-of-return regulation
Encyclopedia
Rate-of-return regulation is a system for setting the prices charged by regulated monopolies
. The central idea is that monopoly firms should be required to charge the price that would prevail in a competitive market, which is equal to efficient costs of production plus a market-determined rate of return
on capital.
Rate-of-return regulation has been criticized because it encourages cost-padding, and because, if the allowable rate is set too high, it encourages the adoption of an inefficiently high capital-labor ratio. This is called the Averch–Johnson effect.
Rate-of-return regulation was dominant in the US for many years. However, as other countries have introduced monopoly regulation, often following the privatization
of nationalized industries, they have mostly adopted other systems, such as price-cap regulation
and revenue-cap regulation
, which are seen as having better incentive properties. However, it has been argued that all systems of regulation converge to rate-of-return regulation in the long run.
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...
. The central idea is that monopoly firms should be required to charge the price that would prevail in a competitive market, which is equal to efficient costs of production plus a market-determined rate of return
Rate of return
In finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or...
on capital.
Rate-of-return regulation has been criticized because it encourages cost-padding, and because, if the allowable rate is set too high, it encourages the adoption of an inefficiently high capital-labor ratio. This is called the Averch–Johnson effect.
Rate-of-return regulation was dominant in the US for many years. However, as other countries have introduced monopoly regulation, often following the privatization
Privatization
Privatization is the incidence or process of transferring ownership of a business, enterprise, agency or public service from the public sector to the private sector or to private non-profit organizations...
of nationalized industries, they have mostly adopted other systems, such as price-cap regulation
Price-cap regulation
Price-cap regulation is a form of regulation designed in the 1980s by UK Treasury economist Stephen Littlechild, which has been applied to all of the privatized British network utilities...
and revenue-cap regulation
Revenue-cap regulation
Revenue-cap regulation is a system for setting the prices charged by regulated monopolies by limiting the total revenue in a given period. It is contrasted with rate-of-return regulation, in which utilities are permitted a set rate of return on capital, and with price-cap regulation where price is...
, which are seen as having better incentive properties. However, it has been argued that all systems of regulation converge to rate-of-return regulation in the long run.