Price Capping. . RPI – X is the rate of inflation measured by the Retail Price Index and x is cost-savings that the regulator believes the industry can make by becoming more efficient. Each year the industry’s price is allowed to rise by only RPI – X.
Benefits of Price Capping
- Basically, with RPI – X, prices must fall in real terms so prices move closer to P = MC and the firm becomes more allocatively efficient so consumer surplus rises.
- Firms are incentivized to become even more productively efficient than the regulator expects. If a firm increases its productive efficiency by more than x then it keeps all its additional profits.
- The price cap exists for 5 years, firms can plan ahead because they know they will benefit from further efficiency gains.
Costs of Price Capping
- Government failure could occur if regulators over-estimate the cost-savings that an industry can make. Maybe x is set so high that firms must decrease production and investment.
- Regulators could under-estimate the cost-savings that an industry can make. Maybe x is set so low that firms make excessive profits.
- If x is set too short (for example, 2 years) then firms may not invest because they cannot plan ahead.
- Regulatory capture could occur. Regulatory capture occurs when a regulator makes decisions that benefit the regulated firm instead of consumers. Regulatory capture could occur if the regulator believes inaccurate information given to them by the regulated firm. Maybe the firm feeds misleading or wrong information about its costs and claims it cannot become more efficient so it must continue to charge high prices.
- The government may not be able to set x accurately. The industry and firms are the ones who know their own costs and potential efficiency. The government must research but they may not be able to fully identify the firm’s cost structure.