Price-Cap versus Rate-of-Return Regulation in a Stochastic-Cost Model

A stochastic-cost model is used to show that both price-cap and rate-of-return regulation lead to overinvestment in capital and to excessive managerial slack. However, they differ in stochastic versus fixed intervals between hearings and in the use of test-year costs versus average costs since the previous hearing. A numerical example illustrates that fixed intervals between hearings improve welfare if hearings are not held too frequently, but most gains go to the firm. More significantly, the use of average-cost data combined with fixed intervals results in dramatic welfare improvements, with most gains going to consumers.