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IAI Actuarial Core Principles · Business Economics · Relationship between the government and the individual firm

A financial regulator moves from rate-of-return regulation to price-cap regulation for a monopoly utility. Which outcome is the most likely consequence, and why?

Price-cap regulation strengthens the incentive to cut costs because the firm keeps savings below the cap, but it creates a risk that the firm lowers service quality to raise profit. Rate-of-return regulation instead dulls cost incentives by linking allowed revenue to costs.

  1. ALower incentive to cut costs, because profits are reduced one-for-one with cost savings
  2. BHigher incentive to cut costs, but a risk that service quality is cut to boost profitCorrect
  3. CNo change in incentives, because both fix the firm's profit
  4. DHigher prices, because the cap removes all competition
  5. Lower regulatory information needs, because costs no longer matter at any review

Explanation

Under a price cap the firm keeps savings below the cap, so it has stronger cost incentives. Because revenue per unit is fixed, it may also cut quality, which regulators must monitor. Option A describes rate-of-return regulation, where savings are competed away through lower allowed prices.

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