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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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.