Question

Most public utilities (gas, electricity, water, and local telephone companies, for instance) are subject to rate of return regulation, under which a firm is allowed to choose its price, subject to its proving that it is not earning too much money. Typically, the firm is allowed to cover its expenditures for labor and material exactly and to earn a "fair" rate of return on its capital investment. Can you think of any problems with this sort of regulatory scheme? In particular, what do you think that this plan does to the firm's incentives to substitute capital for labor?

Answer 1

The main objective of the sort of regulatory scheme mentioned in the above case is to provide public utilities at an affordable rate to people since these are a part of public utilities which should be provided at a rate which is affordable to all the people of the region. But with such low prices of these public utilities, the private sector firms are not willing to enter because of lack of profit opportunities for the private players. This reduces competition in the market for public utilities and thus public players have no incentive to improve their efficiency and innovative is less in these public utility services because of lack of competition.

With this regulatory scheme, the firms can only cover their cost and there are lack of profit opportunities and thus the firm's incentive to substitute capital for labor is less because capital is expensive as compared to labor.