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27Apr

Price Regulation Assignment

Definition

Price regulation can be defined as the Government oversight or the control that government exercises directly over the prices of goods and commodities in a particular market. Broadly we can say that, price regulation is the policy which helps different government agencies, legal statutes or regulatory authorities in setting prices. With the help of this policy, a floor price that is the minimum price and / or a ceiling price that is the maximum price can be defined by the aforementioned bodies. Not only maintaining the prices, but price regulation also deals with the specific rules and regulations which determine the amount by which prices can be decreased or increased similarly as the situation of rent controls. Generally, the factors which help in determining the regulated prices tend to vary from case to case. These factors can be costs, return on investment, markup etc.

Why Price Regulation?

Though price regulation is used in many situations but it is most useful and highly used for the markets which are natural monopoly or monopolistic. As already been discussed, a market fails to attain efficiency in terms of production and allocation when the market structure is that of natural monopoly.

Market outcomes of Price regulation assignment
market outcome versus regulated outcomes 

To explain the situation, let us take Figure 1. The figure demonstrates a natural monopoly which stems from economies of scale of production for the firm which sells a particular product. As it can be seen the average total cost curve (ATC) is declining at every point (as a consequence of it the marginal cost curve, MC, lies under the average total cost curve overall in cost-benefit analysis ). Hence we can term the industry as a natural monopoly. Let us assume that this firm in discussion (and regulator) is able to demand only a particular price. This way we can assume that price discrimination in this particular example is invalid. In absence of proper price regulation by the authorities, the firm will tend to maximize profits by equalling marginal revenue and marginal cost. This will make the price PM and quantity produced QM. In this case, to obtain productive efficiency, it is necessary to produce at the lowest point of the average total cost curve. It can be seen that the market outcome violates this condition. To obtain allocative efficiency it is necessary that production takes place where the marginal cost curve intersects the demand curve. It can be seen again that the market outcome does not satisfy this condition. Relative to the social optimum, as we can see here social welfare is decreased by the areas A, B, C and D. This area is defined as the deadweight loss in this situation and it is not a preferable situation. To avoid this situation price regulation is exercised by the government. (Read more about : Financial Feasibility Assignment)

Advantages and Disadvantages of Price Regulation

The basic reasons for exercising price regulation in an economy or a particular market should be to discourage unfair game amongst the market players or to make sure that a fair pricing policy is maintained and satisfactory total quality of service is delivered to the consumers where natural monopoly exists. Healthy competition inside an economy gives rise to better growth of productivity, which in turn translates into a rapidly-growing economy. Still in most of the cases regulatory bodies fail to exercise the regulation properly.

Practitioners opine that an advantage of price regulation is that it seldom affects the decision regarding the choice of the production process which will be used. It is also said that in the case of price regulation very less number of problems regarding implementation and enforcement can be faced. An analysis of price regulation is shown in the Figure 2. As we have already seen before, a natural monopolist with profit maximization as his only intention produces amount q* and fixes selling price at p* in an unregulated environment.

efficiency gain from price regulation
efficiency gain from price regulation

If the regulatory authority intervenes and fixes the price at a regulated level of p’, it disturbs the marginal revenue schedule of the monopolist. Since the monopolist is still able to produce and sell more number of units produced, say the amount q’, at the previously regulated price of p’, the marginal revenue that the monopolist will acquire over this amount of output is equal to the maximum price that is imposed. If the output level is increased further from this point q’ it will lead to a reduction in price beyond point p’ and in that case marginal revenue will shift to the original marginal revenue curve MR. Hence we can see that full marginal revenue curve of the natural monopolist whose price has been regulated is shown by the discontinuous line p’abMR.

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Hence a natural monopolist with intention of profit maximization in a regulated environment will produce q’ amount of output. Till q’, in a regulated scenario, marginal revenue will always be more than marginal cost. Once the quantity produced surpasses q’ marginal cost will exceed regulated marginal revenue. Thus regulation helps the consumers to a gain that amounts to the area p*eap’ by the means of decrease in price and rise in the quantity of output. The area p*eap’ is geometrically equal to the area of eabd. (The original marginal revenue curve represents the extra amount that will be paid by the consumers for an additional unit of output. Hence the vertical distance between these two curves shows the gain to consumers if they consume an additional unit.) The profit that the monopolist earns has decreased by the area bed (this is also the difference between marginal cost and marginal revenue). Hence the difference between the gains to consumers and the loss to producers can be shown by the area eacd. Since eacd is a geometrically viable area it represents a positive quantity which means that the consumers are gaining due to the exercise of price regulation. The regulation here has been done without any apparent effect on input decisions of the monopolist firm. Hence it can be safely concluded that a profit maximizing firm whose price has been regulated will operate with the cost curves same as a firm which has not been regulated.

A close examination of the relationship between the regulatory authority and regulated firm will prove that this analysis is not complete in its true sense. The basic drawback of this analysis is that while regulating the price the regulatory body can’t do it without some criterion based upon which it will decide the regulated price. In Figure 2, for example, a regulator whose sole intention is to safeguard consumer interests can try to obtain an average cost price citing the reason that this is the bare minimum price that can be achieved where the monopolist will avoid losses. But the way costs and prices has been connected in this scenario gives rise to bargaining problems, These kind of problems can also be faced in the situation where rate of return regulation is exercised. The regulating authority will have little or no knowledge about the costing which is applicable for the monopolist firm. If the firm gets to understand that the regulated price that will be determined for it will depend on the cost estimate of it, it will show a tendency to distort its estimated future costs and increase it to a level where the regulated price will have no positive effect on the consumers. Moreover if the firm appreciates that the all the costs they are going to hike will actually change the regulated price in sync with them, it will lose the incentive to attain technological efficiency. Without competition in the market and with a regulation policy which bases itself on the firm’s costing, the practice of hiding profits as costs will be getting popular.

The other very important drawback of price regulation is that in the process of regulation it determines the number of units produced of the output on which the price regulation will be exercised. The monopolist in questions will be supplying a bucket of various services or goods in most of them times. These goods and services will naturally be affected to intentional downgrade of quality. For stopping the monopolist firm from tampering with the quality to respond to the regulation, regulatory policies should also determine the quality of the output along with simple price regulation. The time, manpower and money needed for keeping check on quality and other involved standards for each and every different goods and services produced and marketed by the monopolist firm is huge. It will lead to simplification of the total procerss by regulating a price index of a basket of the goods and services produced by the monopolist firm. In this process the quality standard will be defined pretty loosely and will lead to random violation of policies by the firm. Not only this, the process will also provide the monopolist firm ample chance to tweak the relative prices of items which belong to the same basket and will give the firm total freedom to keep the prices of the items which do not belong to the basket according to their wish. This process is called tariff-rebalancing.

Other than these, price regulation often faces other difficulties also. One of them is the absence of any kind of manual which may help the regulatory bodies for implementing market-supporting regulations. It is a very tough decision to take for the regulators when they try to determine rules of competitions of debatable areas such as predatory pricing and intellectual property. In these cases they need to be very careful and balance their decisions accordingly. They have to understand that rules and regulations with an intention of protecting consumers (consumer law act) may be very good, but that should not come at the cost of innovation.

Conclusion

Adam Smith, in his famous book The Wealth of Nations said, “The market price of any particular commodity, though it may continue long above, can seldom continue long below its natural price. Whatever part of it was paid below the natural rate, the persons whose interest it affected would immediately feel the loss, and would immediately withdraw either so much land or so much labor, or so much stock, from being employed about it, that the quantity brought to market would soon be no more than sufficient to supply the … demand. Its market price, therefore, would soon rise to the natural price. This at least would be the case where there was perfect liberty.”

The process of price regulation where a pre defined price is imposed on a market which is functioning properly and is enough competitive acts upon the economy as a whole by decreasing the quantity of trade in that market and giving impetus to waste limited resources. Many economists are of the opinion that price regulations tend to decrease the incentive for entering and investing in a market in the long run. Price control, as we can see in different third world countries, degrades quality of the product, creates black market practises and encourages rationing of the products which is a costly process.

Though the regulatory bodies and the policymakers do have the knowledge that price regulations if not exercised with due diligence can harm the economy, they maintain the prices at a low level with subsidy for their own good. This in the long run ruins the economy. In this process with the help of regulating policies the government lowers the price of a particular commodity to some particular price in the economy and doesn’t go for a logical number. It also sets the price to a pre defined amount below that of other customers. In this illogical process, the pre defined price that has been determined by the government increases due to the steps taken for regulation of price. They do not change due to the change in the dynamic interaction of demand and supply Chain forces in the economy. These strong arguments which are given against the price regulation policy proves that the regulatory process is somewhat flawed and may act adversely for the economy if it is wrongly used.

References

  1. Baron, David P. and Besanko, David A. (1984b), ‘Regulation and Information in a Continuing Relationship’,  Information Economics and Policy, 267-302.
  2. Acton, Jan Paul and Vogelsang, Ingo (1989), ‘Price-Cap Regulation: Introduction’, Rand Journal of Economics, 369-372.
  3. Aigner, Dennis J. (1984), ‘The Welfare Econometrics of Peak-Load Pricing for Electricity: Editor’s Introduction’, Journal of Econometrics, 1-15.
  4. Coursey, Don L. and Smith, Vernon L. (1983), ‘Price Controls in a Posted Offer Market’, American Economic Review, 218-221.
  5. Courville, Léson (1974), ‘Regulation and Efficiency in the Electric Utility Industry’, Bell Journal of Economics, 38-52.
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