Rate-of-return Regulation

Rate-of-return Regulation

Rate-of-return regulation is a system for setting the prices charged by government-regulated monopolies. The main premise is that monopolies will be compelled to charge the same price that would ideally prevail in a perfectly competitive market, which is equal to the efficient costs of production plus a market-determined rate of return on capital.

Rate-of-return regulation has been criticized because of the fact that it encourages cost-padding, and because, if the rate is set too high, it encourages regulated firms to adopt inefficiently high capital-labor ratios. This is known as the Averch-Johnson effect, or the Gold-Plated-Water-Cooler effect. Due to the nature of rate-of-return regulation there is no incentive for regulated monopolies to minimize their capital purchases since prices are set equal to their costs of production.

Rate-of-return regulation was dominant in the United States for a number of years in the government regulation of utility companies and other natural monopolies. Were these firms to remain unregulated, they could easily charge far higher rates, given that consumers would pay any price for goods such as electricity or water.

Read more about Rate-of-return Regulation:  Method of Regulation, Advantages of Rate-of-Return Regulation, Disadvantages of Rate-of-Return Regulation and Criticism, History of Rate-of-Return Regulation

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