find it difficult to correctly draw a diagram like Figure 12-8. In the
absence of accurate data, regulators have tended to judge prices
according to the level of the regulated firm’s profits. Regulatory agencies
tend to permit price increases only when profits fall below “fair” levels
and require price reductions if profits exceed such levels. What started as
price regulation becomes instead profit regulation, which is often called
rate-of-return regulation. Concepts of marginal cost and allocative
efficiency are often ignored in such regulatory decisions.
If average-cost pricing is successful, only a normal rate of return will be
earned; that is, economic profits will be zero. Unfortunately, the reverse
is not necessarily true. Profits can be zero for any of a number of reasons,
including inefficient operation, excessive salaries or employee benefits,
and misleading accounting. Thus, regulatory commissions that rely on
rate of return as their guide to pricing must monitor a number of other
aspects of the regulated firm’s behaviour in order to limit the possibility of
wasting resources. This monitoring itself requires a considerable
expenditure of resources.