Edexcel Economics: Unit 3 Business Economics and Economic Efficiency (June 2014) EC03

Well, the specification states that we need to be able to compare and evaluate the strengths and weaknesses of methods of regulation. In this case, I will be talking about price capping and the strengths and weaknesses for price capping.

What is regulation?

Regulation is the direct control by government of firms, and is used when market forces are inadequate to ensure that monopoly firms do not abuse their market dominance. The government acts as a 'surrogate' for competition by making firms cut prices, or take legal action If the regulation is not followed, the firm can be fined.


What is price capping?

Price capping is a form of regulation and is used to regulate price utilities e.g. water companies, train-operating companies in the UK.
It is the upper limit for the price increase that firms can add to prices and it takes into the account of level of RPI inflation.
Although price capping has been phased out as most utility markets have become more competitive.


RPI - X

'X' is the factor determined by the regulator, and it represents the efficiency gains that the regulator has determined can be achieved by the firm.
So for example, if inflation is 5%, and X is 3%, than an industry can raise their prices on average by only 2% per year.


RPI + K

'K' accounts for the additional capital spending that the firm has agreed with the regulator. For example, it is used by water regulators e.g. Ofwat to determine the price for each of the regional water companies in the water industry. K factor is different for each of the water companies e.g. Thames Water's K factor could be 2.5%, whereas Bristol Water's K factor could be 3%. The K factor depends on how much they need to spend to maintain and improve water quality of service. The same concept applies for train-operating companies.


Advantages of price capping:

- Firms can keep the profits it makes through bringing about greater efficiency gains.

- Because the 'X' or 'K' factor is usually in place for a period of time, say 5 years, firms are able to plan ahead and know that they will not be penalised for making further efficiency gains.

- Price capping is also an appropriate way of preventing monopolies making excessive profits at the expense of consumers.

- Firms have more of an incentive to achieve other motives for the firm.

- Cuts in the real price levels are good for household and industrial consumers (leading to an increase in consumer surplus and higher real living standards in the long run).


Disadvantages of price capping:

- If the regulator underestimates the efficiency gains a firm can be expected to make, then firms can produce what appear to be excessive profits, although often these profits are used to invest in areas outside the regulator's remit and therefore generate even greater profits in the future.

- Setting different price capping regimes for each industry distorts the price mechanism.

- Price caps have lead to a large number of job losses in the utility industries.

- There have also been suggestions that the regulator and the regulated industry have built up a close relationship, resulting in the regulator being less strict on the firms under its control - this type of close relationship is called 'regulatory capture'.
Why is this a disadvantage? Well, because if there are less strict controls, the firm could potentially increase their prices (exploiting consumers) and make excessive profits in the long run. Is this an act of government failure?

Hi Swaany - do we use the advantages and disadvantages as evaluation then? thanks

Well depends on the question so for example 'assess the advantages of using price capping', your points would be the advantages and the evaluation points (you need to evaluate because the question says assess) would be the disadvantages

Oh okay thanks
Could you send me notes on Shut down point - i dont get it tbh

That's probably like one of the things in unit 3 I dont understand, havent gone over it yet but when i do i'll hopefully explain it to you, but it might not be anytime soon

ewww this unit stinks

na bro - unit 4 is the one that stinks lol

Oh okay thanks
Could you send me notes on Shut down point - i dont get it tbh

na bro - unit 4 is the one that stinks lol

But dem low unit 4 grade boundaries makes up for it somewhat .

i didnt know they were low - that wud be awesome lol

You only need around 75-80 marks for an A* so you can lose around 20-25 out of 100 . Which is pretty generous to be honest.

In the short run:
shut down point will be when average variable costs (AVC) cannot be covered. But even if a loss is making (even if FC cannot be covered) they will continue if short run AVC can be covered.
In the LOng run:
All the costs are variable in the long run. so if AC cannot be covered business will shut down
check this one http://www.slideshare.net/slideshow/embed_code/22276292?rel=0#

Oh okay. Thanks.

Good notes guys What do you think is likely to come up/ predictions? Everyone is saying regulation??

Have you tried private tuition? With a couple of weeks to go you might find this a valuable boost. I'm at Econacademy.co.uk and it costs me £8 per hour. I'm studying A2 Economics and I was awful at evaluation questions. I'm A/A* level now so it's helped me.