A price cap plan typically limits the average price of a basket of services, allowing the firm to change prices for different services by different percentage amounts. The first step in designing a price cap is to determine the number and scope of service baskets.
This decision requires the regulator to weigh the desirability of providing greater pricing flexibility to the regulated firm against the need to protect customers, particularly “captive” customer groups, from high prices.
Pricing flexibility is an important advantage of price cap schemes. In general, the broader the basket, the greater the firm’s flexibility to transition initial prices toward efficient levels (based on underlying costs), and to adapt prices to competitive changes in the market.
Where existing prices bear little relationship to cost, it makes sense to group regulated services in a single price-capped basket. This ensures that overall customers continue to receive the benefits of technical change and cost reductions, while permitting the firm to move towards a competitive rate structure.
Under some conditions a regulated firm could profitably reduce prices for more price-elastic services and raise them for less price-elastic services, without breaching the price cap constraint.
For example, if residential and business customers were placed in the same basket, the regulated firm could lower business prices while raising residential prices. This behaviour is generally consistent with competitive outcomes, but may create customer protection concerns. Where regulators wish to limit this type of pricing flexibility, they can do so by placing the services in separate baskets.
Separate baskets can be used to give different degrees of pricing flexibility to different service categories, particularly where initial relative prices do not reflect underlying cost differences.
For example, the initial price cap plan in the United Kingdom used separate price caps to address the problem of low residential basic subscription rates. Residential access rates were placed in a separate basket, with an initial price cap index of inflation plus 2 percent. The price cap index for the regulated business as a whole was initially inflation less 3 percent. This combination of caps allowed residential access rates to increase towards costs, while ensuring that aggregate regulated service prices fell in real terms.
In the extreme, the regulated firm could seek to reduce prices for more competitive services below costs, increase prices for other services to compensate. Again, using a larger number of smaller baskets will reduce the likelihood of anti-competitive cross-subsidization. Alternatively, regulators can protect competitors simply by putting some type of price floor in place.
RELATED INFORMATION
Assessing Price Variations
Calculating the Productivity Factor
Service Quality Factors
Exogenous Cost Factors