A form of price setting regulation where governments determine the fair price which is allowed to be charged by a monopoly. Rate of return regulation is meant to protect customers from being charged higher prices due to the monopoly’s power, while still allowing the
monopoly to cover its costs and earn a fair return for its owners.
Customers benefit from prices that are reasonable, given the monopolists operating costs. Rate of return regulation is often criticized because it provides little incentive to reduce costs and increase efficiency. A monopolist who is regulated in this manner does not earn more if costs are reduced. Thus, customers may still be charged higher prices than they would be under free competition.
Basics for Assessing Rate of Return
The goal of rate-of-return regulation is for the regulator to evaluate the effects of different price levels on potential earnings for a firm in order for consumers to be protected while ensuring investors receive a “fair” rate of return on their investment. There are five criteria utilized by regulators to assess the suitable rate of return for a firm.
1. The first criterion is whether the rate of return is at a level substantial enough to attract capital from investors. Government regulation of this fashion is meant to ensure that firms don’t abuse their monopoly powers to take advantage of consumers; however, they must also ensure that regulation does not prevent customers from acquiring their essential goods and services. If the rate of return is too low, investors will not be compelled to invest in the firm, preventing it from having the financial capital to operate and invest in physical capital and labor, which in turn would result in consumers being unable to receive their sufficient level of service, such as electricity for their homes.
2. The second criterion that regulators must consider is the efficient consumer-rationing of services provided by regulated firms. To promote consumer efficiency, prices should reflect marginal costs; however, this must also be balanced with the first criterion.
3. Thirdly, regulators must ensure that the regulated monopolistic firm utilizes efficient management practices. Here a regulator can examine whether or not the firm’s leadership is taking advantage of loopholes in regulation by overstating costs in order to be permitted to operate at a higher price level.
4. A fourth criterion a regulator must investigate is the firm’s long-term stability. As above mentioned, one of government’s chief concerns is to ensure consumers are able to receive their required level of service. Therefore, regulators must take into account
the future prospects of the firm, similarly to the way in which a stock-trader would evaluate a company’s future potential.
5. The fifth and final criterion the regulator must take into account is fairness to the investors. This is a separate concern from the first criterion since the regulator must both ensure that the company receives the capital it needs to continue operating and that private investors are receiving fair profits on their investment, otherwise such regulation would likely correspond to a decrease in investment.