Is Cost-of-Service Regulation Worth the Cost?

Cost-of-service regulation that reduces prices will also reduce incentives to control cost. Increased output counteracts this trend when there are economies of scale. We derive closed-form approximations for the maximum cost increase that leaves a positive welfare gain when regulation reduces price by some percentage. To be useful to regulators, these approximations depend only on demand elasticity and the ratio of fixed to total cost. For low demand elasticities typical of regulated industries, price must fall by half to outweigh cost increases of as little as 2%. Cost-of-service regulation appears to reduce welfare unless economies of scale are strong. These conclusions may be reversed if regulators favor consumers, but only a slight bias in favor of the firm exacerbates them. Regulatory methods that preserve incentives to be efficient by divorcing price from cost become more appealing.