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

A natural monopoly in electricity distribution is regulated using a price cap of RPI-X. Which statement best describes the effect of the X factor?

The X factor requires prices to fall in real terms each year. Because the firm keeps any profit from cost savings beyond X, the cap gives it an incentive to improve efficiency, unlike rate-of-return regulation.

  1. AIt requires the firm to raise prices by inflation plus a fixed margin each year
  2. BIt sets real price reductions each year, giving the firm an incentive to cut costs to keep any extra profitCorrect
  3. CIt guarantees a fixed rate of return on capital employed
  4. DIt prevents the firm from earning any profit above normal profit
  5. It sets the price equal to average fixed cost

Explanation

Under RPI-X, allowed average price rises by inflation less X, so real prices fall. If the firm cuts costs by more than X it keeps the gain, providing efficiency incentives. Rate-of-return regulation, not price-cap, guarantees a return and weakens cost incentives.

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