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Is Cost-of-Service Regulation Worth the Cost?

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  • Timothy Brennan

Abstract

Cost-of-service regulation that reduces prices will also reduce incentives to control cost. Increased output counteracts this trend when there are economies of scale. We derive closed-form approximations for the maximum cost increase that leaves a positive welfare gain when regulation reduces price by some percentage. To be useful to regulators, these approximations depend only on demand elasticity and the ratio of fixed to total cost. For low demand elasticities typical of regulated industries, price must fall by half to outweigh cost increases of as little as 2%. Cost-of-service regulation appears to reduce welfare unless economies of scale are strong. These conclusions may be reversed if regulators favor consumers, but only a slight bias in favor of the firm exacerbates them. Regulatory methods that preserve incentives to be efficient by divorcing price from cost become more appealing.

Suggested Citation

  • Timothy Brennan, 1996. "Is Cost-of-Service Regulation Worth the Cost?," International Journal of the Economics of Business, Taylor & Francis Journals, vol. 3(1), pages 25-42.
    • Handle: RePEc:taf:ijecbs:v:3:y:1996:i:1:p:25-42
    DOI: 10.1080/758533486
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    Citations

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    Cited by:

    1. Brennan, Timothy, 1999. "Do Lower Prices For Polluting Goods Make Environmental Externalities Worse?," RFF Working Paper Series dp-99-40, Resources for the Future.
    2. Brennan, Timothy J., 2000. "The Economics of Competition Policy: Recent Developments and Cautionary Notes in Antitrust and Regulation," Discussion Papers 10716, Resources for the Future.
    3. Timothy Brennan, 2010. "Decoupling in electric utilities," Journal of Regulatory Economics, Springer, vol. 38(1), pages 49-69, August.
    4. Timothy Brennan, 2013. "Mitigating Monopoly or Preventing Discrimination: Comparing Antitrust to Regulatory Goals in the Interstate Commerce Act," Review of Industrial Organization, Springer;The Industrial Organization Society, vol. 43(1), pages 103-119, August.
    5. Krouse, Clement G & Cabolis, Christos & Danger, Kenneth L & Carter, Tanja D & Riddle, Jon M & Ryan, Daniel J, 1999. "The Bell System Divestiture/Deregulation and the Efficiency of the Operating Companies," Journal of Law and Economics, University of Chicago Press, vol. 42(1), pages 61-87, April.

    More about this item

    Keywords

    Regulation; Cost-of-service; Rate-of-return; Incentive regulation; JEL classifications: L51; L21; D21; D78.key;
    All these keywords.

    JEL classification:

    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation
    • L21 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Business Objectives of the Firm
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory

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