Incentives for cost reduction under price cap regulation

In this article, we present a formal analysis of the incentives for cost reduction under a regime of price-cap regulation. We assume price-cap regulation establishes a ceiling below which a monopolist has complete price flexibility, while prices above the ceiling are subject to cost-based regulation. Our main conclusions are that a marginal reduction in the price cap increases the regulated firm’s investment in cost reduction. However, very low price caps might destroy investment incentives completely. Therefore, investment is a discontinuous function of the price-cap level.