Monopoly Regulation, Chilean Style: The Efficient-Firm Standard In Theory And Practice

This paper analyses the foundations of “efficient-firm” regulation (implemented in Chile for almost two decades), and the formulas that are used to set the prices of water/sanitation companies, electric power distributors and the dominant phone companies. We show that efficient-firm regulation implies setting prices equal to long-run average cost, which is optimal when the firm is required to be self-financing. In contrast, this is not true of the best-known alternatives, namely regulation based on rate-of-return or a price cap. We also show that in both efficient-firm and price-cap regulation, the fixed and exogenous period that is maintained between price-setting processes stimulates productive efficiency. We argue that the price-setting formulas and procedures used assume that the regulator has sufficiently precise information to determine the costs of a hypothetical efficient firm, without the need for information from the real firm. Nonetheless, modern regulatory theory and practice both show that prices cannot be set without drawing upon information that only the real firm possesses. The model developed in this paper is used to discuss the potential gains from replacing efficient-firm regulation by a price cap. We conclude that price-cap regulation also requires considerable amounts of information from the real firm; so, for the time being, Chile should focus on improving regulatory procedures, rather than changing the underlying mechanism.