question archive 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 it proving that it is not earning too much money
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 it proving that it is not earning too much money
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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 it 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 this plan does to the firm's incentives to substitute capital for labor?
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The regulatory scheme was initiated due to the firm's monopoly nature who are providers of essential services. As the gas, electricity, water, and so on are the vital services that each person consumes irrespective of his economic status. The providers of these services exhibit the characteristics of a monopoly firm. The government allows the firms to charge the costs and minimum & optimal return on the capital invested by following the antitrust policies. But firms often do not try to minimize the costs of providing these services because they do not see any incentive in this. Therefore, the firm is unable to achieve efficiency. The firm does not get too many returns, and henceforth, they often invest their funds into capital goods. It is because they do not get any incentive for using inputs that exhibit lesser costs.
