Setting the X Factor in Price Cap Regulation Plans

Despite the popularity of price cap regulation in practice, the economic literature provides relatively little guidance on how to determine the X factor, which is the rate at which inflation -adjusted output prices must fall under price cap plans. We review the standard principles that inform the choice of the X factor, and then consider important extensions. We analyze appropriate modifications of the X factor: (1) when only a subset of the firm's products are subject to price cap regulation, and when product-specific costs and productivity cannot be measured; (2) when the pricing decisions of the regulated firm affect the economy-wide inflation rate; and (3) in the presence of structural changes in the industry, such as a strengthening of competitive forces.