413. Price Regulation and the Cost of Capital

Fernando T. Camacho and Flavio M. Menezes, School of Economics Discussion Paper No. 413, October 2010, School of Economics, The University of Queensland. Australia.

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Abstract

This paper investigates how price regulation under moral hazard can affect a regulated
firm’s cost of capital. We consider stylised versions of the two most typical regulatory frameworks
that have been applied over the last decades by regulators: Price Cap and Cost of Service. We
show that there is a trade-off between lower operational costs and a higher cost of capital under
Price Cap regulation and higher operational costs and lower cost of capital under Cost of Service
regulation. As a result, when the extent of moral hazard is not significant, Price Cap regulation
generates lower welfare than the Cost of Service regulation.