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

A regulator imposes a price cap on a natural monopoly using an RPI-X style formula, where prices may rise each year by inflation minus X. What is the main economic purpose of the X factor?

The X factor shares expected efficiency gains with consumers by forcing real prices to fall, while letting the firm keep any extra savings it achieves beyond X. This preserves the incentive to cut costs, unlike rate-of-return regulation which guarantees a return.

  1. ATo pass all cost increases on to consumers
  2. BTo share expected efficiency gains with consumers and give the firm an incentive to cut costsCorrect
  3. CTo guarantee the firm a fixed rate of return on capital
  4. DTo eliminate all supernormal profit immediately
  5. To raise barriers to entry for new firms

Explanation

The X factor reflects expected productivity improvements, forcing real prices down over time. A firm that beats X keeps the extra profit, so it has an incentive to cut costs. Rate-of-return regulation, not price capping, guarantees a return and weakens cost incentives.

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