3.1.8.8 - Regulation and deregulation

What regulation changes

Regulation sets or enforces rules governing economic activity. It can restrict prices, require quality or safety, oblige network access, control pollution or specify information that sellers must disclose. Regulation can apply under public or private ownership. Its economic case depends on a particular market failure, not simply on a market being unpopular.

A natural monopoly may have too little competitive pressure to keep prices near costs. A price rule can constrain its mark-up while preserving network scale economies. Safety and quality standards can protect buyers who cannot observe product risks; disclosure can reduce asymmetric information. An emissions standard makes a harmful activity more costly to undertake, encouraging abatement or reducing output.

Rules also consume resources. Compliance uses staff and equipment; inspections use public funds. A fixed licence fee can disproportionately burden small entrants. A rule with little effect on harm but a large entry cost can reduce rivalry and raise prices. Evaluate the benefit against the real compliance and enforcement costs, including who bears them.

Price control and cost incentives

Regulating a monopoly requires balancing affordable prices with efficient investment. A regulator needs information about costs, demand and service quality, much of which the firm knows better. If prices are based on whatever costs the firm reports, managers may have a weak incentive to remove waste.

An illustrative price cap allows a maximum price increase equal to an inflation rate minus an expected efficiency gain, often called an RPI–X style rule. If assumed inflation is 3% and the efficiency adjustment is 1 percentage point, permitted price growth is 2%. A £100 charge can become at most:

This is a teaching example, not Ofwat's actual calculation. Holding the permitted price path fixed for a period lets the firm retain gains from cutting costs faster than expected, providing an efficiency incentive. Periodic review can pass some gains to customers later. But an excessively tight cap can weaken investment or quality; a generous cap can allow unnecessary profits. Quality obligations and credible investment allowances matter alongside price.

Illustrative evidence of success would be a bill rising from £100 to £102 when general prices rise by 3%, alongside improved reliability. The nominal bill rises but less than the general price level. If service quality deteriorates sharply, the smaller rise is weaker evidence of improved consumer welfare. Price and quality must be considered together.

Deregulation and entry

Deregulation removes or relaxes rules restricting economic activity. Removing unnecessary entry licences can let new suppliers compete, increasing contestability and pressure on incumbents. Firms may cut mark-ups, offer new services and adopt cheaper technology. Lower business input costs can support productivity elsewhere in the economy.