Regulating by Capping Prices

Abstract

The purpose of this article is to look at the theoretical underpinnings and properties of price caps, specifically, the rules governing how a multiproduct regulated firm may adjust its prices. To identify a standard for implementing price caps, we begin by identifying the constrained optimization to which “price caps” are the solution. Since price caps are at heart a policy in which a firm can do what it likes as long as prices do not rise, the relevant optimization is maximization of welfare or profit subject to a constraint that aggregate consumer welfare must not fall below a given level. Permitting prices to be flexible, subject to maintaining a constant weighted average where the weights are based only upon the quantities sold for each service, can approximate the behavior of a firm maximizing profit subject to an aggregate consumer surplus constraint. Flexibility to change prices is in this sense “optimal,” subject to the acceptability of the consumer welfare achieved under the original prices.