What Is Rate of Return Regulation?

Rate of return regulation is a form of price setting regulation where governments determine the fair price which is allowed to be charged by a monopoly. It is meant to protect customers from being charged higher prices due to the monopoly's power while still allowing the monopoly to cover its costs and earn a fair return for its owners.

Understanding Rate Of Return Regulation

Rate of return regulation was used most often in the United States to price goods and services offered by utility companies, like gas, television cable, water, telephone service, and electricity. A history of antitrust sentiment and antitrust regulation led to the implementation of rate of return regulation in the U.S., which was upheld by the 1877 Supreme Court case Munn v. Illinois and further developed through a series of cases beginning with Smyth v. Ames in 1898.

Rate of return regulation allowed customers to feel that they were getting a fair price for essential services while allowing investors to feel that they were getting a fair return on their investments in these industries. Rate of return regulation remained common in the U.S. through much of the 20th century, gradually being replaced by other, more efficient methods, such as price-gap regulation and revenue-cap regulation.

Advantages and Disadvantages of Rate of Return Regulation

Customers benefit from prices that are reasonable, given the monopolist's operating costs. It offers long-term rate sustainability, as it provides some resistance for rates against the popularity of a company among investors and against changes that might take place within that company. It provides stability in monopolized industries, while preventing monopolies from making large profits with price-gouging. Investors, while they will not make huge dividends, will benefit from substantial and consistent returns. Customers do not feel as if they are being overcharged for essential services, and the monopoly in question benefits from a stable public image as a result.

Rate of return regulation is often criticized because it provides little incentive to reduce costs and increase efficiency. A monopolist who is regulated in this manner does not earn more if costs are reduced. Thus, customers may still be charged higher prices than they would be under free competition. Rate of return regulation can contribute to the Averch-Johnson effect, whereby firms thus regulated accumulate capital and allow it to depreciate in order to subvert the system and obtain governmental permission to raise rates.