as introducing the risk of under-investment in the longer run (Armstrong and Sappington, 2006).
However, this characterisation is too stark as the extent to which a particular regime supports
investment depends considerably on the overall set-up of the regime. In this context, the next sub-
sections discuss the factors that will result in over- and under-investment.
2.1. Rate-of-return regulation and over-investment
Under rate-of-return regulation, prices are set to account for the production costs of the firm and
the margin (the “plus factor”) that is allowed by the regulator or agreed on between the regulator
and the firm.3 The “plus factor” can specifically relate to the return the firm is allowed to earn on
its capital. This return, often coined “fair” rate of return, should allow the firm to recover
investment costs. The prices are adjusted upon the initiative of the regulated firm, the regulator or
consumer representatives if production costs increased or decreased after the last regulatory
review.
Rate-of-return regulation may encourage the regulated monopoly to over-invest in network
capacity and lead to allocative inefficiency. Over-investment occurs if the regulated fair rate of
return exceeds the cost of capital leading the regulated monopoly to substitute capital for labour
in order to increase profit. At the same time, the high capital-labour ratio will result in a
production structure that is not cost efficient (Averch and Johnson, 1962; Takayama, 1969).
Over-investment due to high capital-labour ratio will result in higher levels of quality if service
quality is a function of capital intensity.4 More generally, over-investment and the ensuing excess
capacity may be used as a strategic tool to deter potential entrants and empire-building managers
may be tempted to increase investments because a larger company size results in higher status and
material rewards (Starkie, 2006).
2.2. Incentive price regulation and under-investment
The underlying idea of price cap regulation is to simulate conditions of perfect competition by
imposing a price cap over the regulatory period adjusted for changes in (exogenous measures of)
3. The costs of a regulated firm can be split into operating costs, the rate of return on the firm’s
capital, and the depreciation of the firm’s capital. In this context, the regulator sets the prices so
that expected revenues for the period ahead equals expected operating costs for the next period,
the rate of return on the firm’s capital plus the depreciation of the capital stock.
4. The over-supply of service quality may be exacerbated when firms anticipate a change from a
low-powered (rate-of-return) to a high-powered (incentive) regulatory price regime if they
believe that they can continue to provide the same service quality relying on equipment installed
before the regime change (Sappington, 2005).