6 - Regulatory Rules to Set the Average Price

Summary

The optimal form of regulation of the average price depends on the relative importance of the various sources of information asymmetry influencing the cost levels. Theory provides two main insights that hold, irrespective of the main source of distortion. The first is that the average regulated price needs to include a temporary payment to cover the price the regulator must pay to get the missing information and this price should be seen as an additional cost. The second is that the regulators should set up a menu of desirable contracts and allow the firms to self-select the contract type that best matches their capacity and risk-taking preferences; good firms (low costs) tend to prefer fixed-price contracts and bad firms (high costs) tend to prefer cost-plus. There are three main approaches to set the average price in practice: cost-plus, price caps and hybrids. Various forms of performance benchmarking can be useful complements to close the informational gap on costs and to shame poor performance (sunshine regulation). In practice, most countries are evolving towards hybrid forms of regulation emphasizing the need to account for the multiplicity of regulatory goals and informational constraints.