PRICE REGULATION: CEILING PRICES
Price Freezes only work for short periods of time (less than a year)
Longer term price controls require:
*A formula for computing a binding limitation on prices
*An automatic adjustment procedure which requires some index that
indicates the maximum amount of adjustment that can be made
- inflation adjustment formula,
- cost justification formula tailored to a specific firm (or group), or
- panel of experts that makes ad hoc adjustments
*An exceptions, exemptions procedure which places heavy burdens
on the firms that are regulated
Getting out of controls raises inflation rates
*Inflation anticipatory of decontrol
*Post control excessive swings before the market readjusts
Price Control Formulas
1. Item-by-item price (infeasible quantity)
2. Percentage adjustment based on the inflation rate
(inequitable due to different value added)
3. Cost justification formulas (hard to audit or verify)
4. Profit margin (profit-to-sales ratio: inequitable due to different
turnover ratios, viz. sales/inventory)
5. Return on investment (profit-to-capital ratio: not computed by
most companies and non-standardized measures of capital)
CONTROL ON THE
RETURN ON INVESTMENT
TR-TC
K
=
Permitted rate of return by regulatory commission
where TR= total revenue,
TC=total cost,
K= capital invested
The constraint on profit is exercised
by the rate base (K).
METHODS FOR VALUING THE RATE BASE
•Original Cost: the actual cost of the plant
is quickly out of date, particularly when inflation is bad
does not reflect the obsolesence of the technology
•Reproduction Cost: Cost today of the exact same plant
who would want to buy out-of-date capacity?
hard to get true market value
•Replacement Cost: cost today of same capacity to produce output,
but using the latest technology.
hard to get accurate data on what this cost might be
•Fair Value: The court’s attempt to determine how to value the
Rate base- usually a combination of original
and reproduction
arbitrary from one court to the next.
CASES DEFINING RATE REGULATION
Smyth vs. Ames: The Commission must determine
a fair value for the rate base. This value is the
province of the court to accept or reject
FPC vs. Hope Natural Gas: “If the total effect of the rate
order cannot be said to be unjust and unreasonable
judicial inquiry… is at an end.” The court defers
to the regulatory authority
Consolidated Edison Electric Rates: the use of a “test year”
for valuing the rate base.
INFLATION EFFECTS ON THE RATE OF RETURN:
How does inflation affect a firm’s rate of return?
CASES: Smyth vs. Ames: “fair return”
Hope Natural Gas: “the return to the equity owner should be
commensurate with returns on investments from other
enterprises having corresponding risks”
Consolidated Edison Electric Rates (1973) provided an explicit
example of the setting of rates
MADISON GAS AND ELECTRIC RATE HEARING:
•Three types of charges- demand, customer, and commodity
•The customer should be charged the cost he is responsible for
•Long-run marginal tests are the basis for determining rates
KEY QUESTIONS ABOUT REGULATING PRICES
What prices can’t the Regulatory commission Control?
What prices can it control?
What is the effect of depreciation on a firm’s rate of return?
What is the effect of regulatory lag (Commission does not
adjust prices quickly enough?)
How is the rate structure determined?
• Why is price discrimination necessary for some public utilities?
• Does price discrimination by the public utilities
contradict antitrust purposes?