LOWERING PRICES CHARGED BY THE PRIVATISED UTILITIES: ‘OUTPUT FLOOR’ REGULATION WOULD BE MORE EFFECTIVE THAN RPI-X

Regulatory mechanisms known as output floors, which share the desirable properties of RPI-X price cap regulation but not its drawbacks, would be a better way of regulating the UK’s privatised utilities - increasing firms’ incentives to reduce costs and lowering the average prices paid by consumers. That is the conclusion of Gianni De Fraja and Elisabetta Iossa, writing in the September issue of the Economic Journal. But since the introduction of output floor regulation would cut shareholders’ profits and management remuneration, it is likely to be resisted by the very firms to which it should apply.

The researchers note that price cap regulation for privatised utilities has now been in operation for several years. The verdict on this mechanism is generally positive. But periodically, it comes under attack because of the very high profits - and managerial perks - it seems to allow the regulated firms.

Of course, it is a built-in feature of the RPI-X mechanism that price is unresponsive to economic conditions since it is fixed by the regulator. This gives the firm a strong incentive to reduce its costs, because it knows that it will be able to keep (and distribute to shareholders and managers) all the additional profit generated by cost reductions.

The downside, of course, is that shareholders and managers keep the entire profit gain due to a cost reduction - even when the cost reduction is entirely due to external factors outside the control of the firm. If, for example, firms enjoy a windfall profit due to lower input prices, then consumers do not receive a share of this windfall.

De Fraja and Iossa show that if, instead of asking the firm to maintain its average price below a certain level (a price cap), the regulator asks it to maintain its average output above a certain level (an output floor), there are several beneficial outcomes:

First, the incentive for cost reduction in the regulated firm is strengthened, and therefore, in the medium term, costs will be lower.
Second, the average price paid by the consumer will also be lower than it would be with price cap regulation. This is because a form of profit-sharing occurs: when outside conditions turn out to be good and not because of the firm’s efforts, then the benefit is shared between the firm and its consumers, rather than accruing to the firm only as with price caps.
The superior performance of output floors happens whenever the regulated firms are exposed to competitive pressure. Indeed, the researchers demonstrate that the two mechanisms (price cap and output floor) were conceptually equivalent at the time of privatisation, when regulation was first introduced and when competition in the regulated industries was limited.

The reason for the different performance of the mechanisms in a competitive environment is quite simple. When the regulated firm competes with other firms, good external conditions (such as lower input costs) affect all firms, hence inducing the competing firms to increase their supply. This in turn increases the competitive pressure on the regulated firm, which must reach the output target set for it by the regulator: it will do so both by working harder to reduce costs, and by lowering prices.

In other words, an output floor allows the competitive pressure in the market generated by good economic conditions to lower the (average) price. This is not the case under a price cap, where by definition the price is fixed by the regulator.

Note for Editors: ‘Price Caps and Output Floors: A Comparison of Simple Regulatory Rules’ by Gianni De Fraja and Elisabetta Iossa is published in the September 1998 issue of the Economic Journal. De Fraja is in the Department of Economics at the University of York; Iossa is at ECARE at the Free University of Brussels. Their research received support from the Economic and Social Research Council’s (ESRC) research programme on Contracts and Competition.

For Further information: contact Gianni De Fraja on 01904-433767 (secretary (Helen Roberts): 01904-433755 home: 01937-834146; fax: 01904-433759; email: gd4@york.ac.uk); RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or mobile 0468-661095 (email: romesh@compuserve.com); or Elisabetta Iossa on 00-32-2-6504116 (home: 00-32-2-6485779; email: eiossa@ulb.ac.be).