Utility Price and Profit Regulations

The most common method of monopoly regulation is price and profit control. Such regulations result in larger output quantities and lower profits than would be the case with unrestricted monopoly. This situation is illustrated in Figure 13.3. A monopolist operating without regulation would produce Qj units of output and charge a price of Pr If regulators set a ceiling on prices at P2, the firm's effective demand curve becomes the kinked curve P2AD. Because price is a constant from 0 to Q2 units of output, marginal revenue equals price in this range; that is, P2A is the marginal revenue curve over the output range 0Q2. For output beyond Q2, marginal revenue is given by the original marginal revenue function. The marginal revenue curve is now discontinuous at Q2, with a gap between points A and L. This regulated firm maximizes profits by operating at Q2 and charging the ceiling price, P2. Marginal revenue is greater than marginal cost up to that output but is less than marginal cost beyond it.

Profits are also reduced by this regulatory action. Without price regulation, price P1 is charged, a cost of C1 per unit is incurred, and Qa is produced. Profit is (P1 - C1) X (Qa), which equals the area P1BFC1. With price regulation, the price is P2, the cost is C2, Q2 units are sold, and profits are represented by the smaller area P2AEC2.

To determine a fair price, a regulatory commission must estimate a fair or normal rate of return, given the risk inherent in the enterprise. The commission then approves prices that produce the target rate of return on the required level of investment. In the case illustrated by Figure 13.3, if the profit at price P2, when divided by the investment required to produce Q2, were to produce more than the target rate of return, price would be reduced until actual and target rates of return became equal. This assumes, of course, that cost curves in Figure 13.3 do not include equity capital costs. The profit that the regulator allows is business profit, not economic profit.

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