Working Paper 99-07
Department of Economics
University of North Carolina, Chapel Hill

Dynamics of price regulation

Gary Biglaiser
Dept. of Economics
Gardner Hall,CB#3305
University of North Carolina
Chapel Hill, NC 27599-3305
919-966-4884 FAX 919-966-4986


Michael Riordan
Columbia University


We study the dynamics of price regulation for an industry adjusting to exogenous technological progress that lowers capital equipment and operating costs. First, we characterize the optimal capacity path and capacity replacement cycles in a neoclassical investment model with a fixed rate of technological progress. The corresponding optimal price path recovers operating costs, the user cost of capital, and a contribution to fixed costs based on Ramsey pricing principles. The user cost of capital includes economic depreciation reflecting the declining replacement value of capacity and foregone operating cost improvements over the economic life of the investment. Second, we show that naive rate of return regulation, which ignores these components of economic depreciation, eventually results in a deficient level of capacity due to excessively high retail prices burdened by the need to recover the underdepreciated costs of historical investments. Naive rate of return regulation also lacks incentives for replacing economically obsolete capacity if accounting rates of depreciation are set too low. Third, we explain, on the one hand, how price cap regulation can incent more efficient capital replacement decisions, and discuss the application of Ramsey principles for the recovery of stranded costs in a transition from rate of return regulation. On the other hand, inefficient replacement of capital may arise depending on the length of the price-cap period. Finally, we use our results to interpret recent regulatory reforms in telecommunications markets.