What is cost-plus regulation?

Cost-plus regulation is a pricing strategy in which the price of a good or service is set at the firm's average cost of production, plus a markup for profit. This allows the company to cover its costs and earn a reasonable profit, while regulators ensure that consumers pay a fair price.

Cost-plus regulation is used in situations where a company has significant market power, such as a monopoly or a few firms dominating an industry. In the absence of effective competition, these firms might set prices too high, harming consumers and reducing overall social welfare. By setting a regulated price, the firm can still make a profit, but consumers are protected from excessive pricing. This is particularly important for industries providing essential goods or services, such as utilities, where competitive forces are weak or nonexistent.

To implement cost-plus regulation, the following steps are generally followed: 1. Determine the company's total costs: Regulators calculate the total costs (fixed and variable) incurred by the company in providing the good or service. 2. Calculate average cost: The total cost is then divided by the total quantity produced to determine the average cost per unit. 3. Establish the markup: Regulators establish a reasonable markup percentage, based on factors such as the nature of the industry, the firm's market power, and the desired level of profitability. 4. Set the regulated price: The regulated price is calculated by adding the markup to the average cost per unit. For example, if the average cost per unit is \(\$10\) and the markup is \(20%\) of the cost, the regulated price would be \(\$10 + (0.20 × $10) = \$12\). 5. Periodic reviews: Regulators periodically review the company's costs and the markup to ensure that the regulated price remains fair and relevant to the current market conditions. By using cost-plus regulation, regulators can strike a balance between protecting consumers from excessive pricing and allowing firms with significant market power to earn a reasonable profit.