Cost-Plus versus Price Cap Regulation
Indeed, regulators of public utilities for many decades followed the general approach of attempting to choose a point like F in Figure 11.3. They calculated the average cost of production for the water or electricity companies, added in an amount for the normal rate of profit the firm should expect to earn, and set the price for consumers accordingly. This method was known as cost-plus regulation.
Cost-plus regulation raises difficulties of its own. If producers are reimbursed for their costs, plus a bit more, then at a minimum, producers have less reason to be concerned with high costs—because they can just pass them along in higher prices. Worse, firms under cost-plus regulation even have an incentive to generate high costs by building huge factories or employing lots of staff, because what they can charge is linked to the costs they incur.
Thus, in the 1980s and 1990s, some regulators of public utilities began to use price cap regulation, where the regulator sets a price that the firm can charge over the next few years. A common pattern was to require a price that declined slightly over time. If the firm can find ways of reducing its costs more quickly than the price caps, it can make a high level of profits. However, if the firm cannot keep up with the price caps or suffers bad luck in the market, it may suffer losses. A few years down the road, the regulators will then set a new series of price caps based on the firm’s performance.
Price cap regulation requires delicacy. It will not work if the price regulators set the price cap unrealistically low. It may not work if the market changes dramatically so that the firm is doomed to incurring losses no matter what it does—say, if energy prices rise dramatically on world markets, then the company selling natural gas or heating oil to homes may not be able to meet price caps that seemed reasonable a year or two ago. But if the regulators compare the prices with producers of the same good in other areas, they can, in effect, pressure a natural monopoly in one area to compete with the prices being charged in other areas. Moreover, the possibility of earning greater profits or experiencing losses—instead of having an average rate of profit locked in every year by cost-plus regulation—can provide the natural monopoly with incentives for efficiency and innovation.
With natural monopoly, market competition is unlikely to take root; so, if consumers are not to suffer the high prices and restricted output of an unrestricted monopoly, government regulation will need to play a role. In attempting to design a system of price cap regulation with flexibility and incentive, government regulators do not have an easy task.
While it is important to consider the efficiency implications and outcomes of those goods and services markets that are not perfectly competitive, it is also fair to consider those input markets that are also not perfectly competitive. This generally occurs in labor markets, where wages, or more broadly labor compensation, is above the perfectly competitive equilibrium. This may occur for multiple reasons, but is often attributed to minimum wage laws or union activity. Minimum wage laws may act like price floors, pushing the legal minimum wage above its equilibrium. While this may be beneficial for those workers who can still find work at the minimum wage, it may also serve to reduce the quantity demanded of labor while simultaneously increasing the quantity supplied of labor. In other words, just like a price floor in a market for a good or service, a minimum wage law can create a surplus. In this case, it is a surplus of labor, causing higher unemployment.
Through its ability to negotiate and collectively bargain with firms, a labor union may have the same impact. As it successfully increases wages for its members, if this increase pushes wages above equilibrium, it will act like a price floor, again creating a surplus of labor. The National Labor Management Relations Act of 1935, the Taft-Hartley Act of 1947, the Labor-Management Disclosure Act of 1959, and the Civil Service Reform Act of 1978 are among the major pieces of regulation governing union activities. Union activity can also be regulated by individual states through so-called right to work regulations. There are 26 states that are right to work states.
There is also the rare case of the monopsony, when there is only one buyer of a good. A monopoly refers to only one seller of a good. Perhaps the best example here is that of the one factory town, where the major or even sole employer is a single buyer of labor. Much like how a monopolist will not produce enough and charge a price that is too high, a monopsonist will hire fewer employees and pay a lower wage than is efficient.