Economic Regulation and Competition (Coursework Sample)

Economic Regulation and Competition
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Introduction
Q1.How do economic regulators deal with risk and uncertainty in a company’s cost projections when setting an RPI-X price cap?
When setting a RPI-X price cap, regulators are usually faced with various challenges that they need to address. This is mainly due to the fluid nature of capitalistic markets. The main challenge regulators face is the risk and uncertainty factors that exist in the market. To counter this, regulators have used various economic techniques. First, setting a cap on revenues is better than setting a cap on the prices. From an economic point, for products and services such as electricity, which demand can vary from time to time, this ensures risk to both companies and consumers are addressed.
Secondly, while setting the price cap, regulators use inflation in relation to the retail (consumer) rice index (RPI). By using this method, regulators minimize risk and uncertainty as expected efficiency savings (X) are factored in when calculating the RPI-X cap. This sum is deducted and returned to the shareholders in turn minimizing the risk of losses on the rate of return on capital employed. In setting the rate of efficiency savings, regulators not only use the company's past performance, but also factors in the performance of other industry players. This ensures that capital employed in the firm is not overly exposed to risks and in a regulated market; firms have a level playing field as the consumers are protected.
Q2. Is the CAPM model a systematic, objective way to set the cost of capital or an opportunity for a regulator to pick almost any number they choose? Justify your answer.
The Capital Asset Pricing (CAPM) model a systematic, objective way to set the cost of capital. The CAPM model is a standard method used to calculate the rate of return on any risk. The model is systematic and objective as it uses market parameters places a value of unsystematic (specific) risk that cannot be mitigated by conventional diversification.
The model, usually employed by shareholders who expect a higher return should their investment face higher risk is objective as it uses the market's performance through Beta (β). Beta measures the relative correlation of the firm to market performance over a certain duration thus providing an objective analysis. In the case of regulators, the CAPM model enables them to set regulations that factor in market performance in relation to the firms' performance. This translates to industry pricing being employed ensuring standard regulation that factors in market forces at risk.
The Capital Asset Pricing (CAPM) model is not a perfect model. However, it provides a theoretical blueprint to be used by all stakeholders to measure risk exposure. Keeping his in mind, in a capitalistic market where investors expect compensation for exposing their investment to risk, regulators used the risk premium to ensure that stakeholders get a return on their investment.
Q3. What are the arguments for and against disaggregating a regulated companies asset beta? When should a regulator consider this?
Disaggregating a regulated company’s asset beta has been the topic of discussion many due to the increasing risks that firms are exposed to. When applying the Capital Asset Pricing (CAPM) model, asset betas accounts for majority of variation in the cost of capital within the model. However, disaggregation of asset beta addresses the issue of asset variation when a firm has varied business operations and activities. Disaggregation of regulated companies’ asset beta is mainly used to measure the variation in the cost of capital arising from different activities.
Advantages of disaggregation of asset beta’s for regulated companies as the allocation of different betas to the various units of firms as different operations may be exposed to different risks. This ensures systematic risk profiles are used in determining the different risk factors. By placing different risk premiums depending on the risk exposure in relation to market forces shareholders will be able to make informed decisions with regard to the firm. In disaggregating asset betas for regulated companies, regulators will use set precedent in risk regulation. This will in turn ensure that regulation takes into count different market forces in play. Finally, in setting regulation, disaggregated asset betas ensure that all risks inherent to the firm are accounted for and addressed. The firm’s beta may be different from the various asset betas thus drawing a better correlation with market forces.
However, there are numerous disadvantages to using disaggregated asset betas for regulated companies. First, economists have not been able to find a reliable method to calculate the asset’s individual betas. Research in the area has shown weakness in the ability to ensure reliable calculation. This has been attributed to various aspects, which include limited information, assumptions made during the calculation of individual beta and the lack of players who are considered "Pure Play”, that is, firm public companies with a single business focus. Some of the methods used to calculate assets’ different betas include cross sectional approach ad the time series approach, which both have their limitations. Secondly, regulators cite the lack of set threshold standards to be met by firms as a disadvantage. Many firms, for example, BT Group in Disaggregating BT’s Beta 2005 report, through exposed to various risks due to its diverse operations in telecommunications and the copper industry, failed to present reliable evidence for the use of different asset betas for its operations. This has been the case without conclusive evidence of other firms. Due to this, the use of disaggregated asset betas has lucked reliability. Finally, geographical limitations in the use of disaggregated beta is another disadvantage. This limitation arises mainly because players who are exposed to similar risks or used in the CAPM model operate in different geographical locations, and exposed to different market risks and regulatory framework.
Regulators should consider the use of disaggregation of asset betas for regulated companies when there is clear evidence of participation in different sectors by the firms. Secondly, when regulators have a reliable way of calculating individual asset betas for the firms that is accurate, and represent a clear picture of market forces. Finally, when there is a set precedent for other firms exposed to similar risks or operating environment and provide conclusive evidence of the same, then regulators should strongly consider the use of disaggregated asset betas for regulation of companies.
Q4. What are the arguments for and against using price caps (RPI-X) to regulate prices?
Regulation of prices in an open market is a tricky affair. This is mainly due to the free market factors that are in play that are harder to manipulate. However, regulation of aspects such as electricity, water, and gas using RPI-X has been wide spread. There are advantages and disadvantages of using price caps (RPI-X) to regulate prices.
One of the main advantages of using RPI-X in the regulation of prices is the use of the state of the industry to increase or decrease the pricing alongside potential efficiency savings. Secondly, companies have the flexibility to adjust the structure of prices within a particular bracket. This strategy gives firms an incentive to cut costs if they cut their costs below X (expected efficiency saving) they can increase their profits. Third, in the absence of competition, RPI-X may be used as a surrogate for competition. This will help to reduce abuse of monopoly. Finally, RPI-X regulation ensures firms are less vulnerable to cost additions, inefficiencies, and over capitalization.
There are numerous disadvantages to RPI-X price regulation. First, the arbitrary nature of the determination of X (expected efficiency saving) is costly and difficult. Secondly, X in theory is not a pricing formula as it is a means of achieving a return on revenue. This in turn makes vulnerable to regulatory capture. This is when market regulators allow firms to increase prices making astronomical profits. Hostility between market regulators and market players is another disadvantage of using RPI-X pricing cap as seen in Britain’s telecommunication industry. Finally, firms may be victims and targeted when they become highly efficient. They may be penalized as a result. This will result in firms maintaining high levels of X, so it can’t keep efficiency saving.
Q5. Why do regulators use different baskets in a price cap – should they use sub-caps instead?
It is normal practice to group services into prices or service baskets. This then enables regulators to come up with a price cap index for the various baskets. This in turn allows the regulator adjust the prices in each group as he sees fit depending on various market factors. The use of different baskets enables regulators set standard parameters, which various services fall. This gives the regulator ease in setting the various prices. However, it is important to note that there are increasing dynamics to the service baskets. It is becoming increasingly important for regulators to use sub-caps in many instances. This will be in an effort to address ad regulate all sectors in the market more efficiently. An example for the need to use sub-caps is in the ever-changing information and telecommunication sector. By bundling certain products together and pricing them, firms may feel at a disadvantage.
Q6. Prices should equal costs plus a mark-up. Discuss.
Product pricing should put into consideration the firm’s return of return, thu...