Towards efficient pricing in monopolistic markets: A theoretical analysis of cost-based revenue caps employing a base-year approach

This paper examines the pricing incentives of a monopolist who operates annually in a market while constrained by an endogenous revenue cap. The time horizon is divided into regulatory periods, each consisting of one base year and multiple non-base years. The revenue cap for each year is determined by the monopolist’s costs in the base year of the previous regulatory period. This regulation is used, among others, to govern electricity distribution operators in Germany. We show that this cost-based revenue cap may incentivize excessive supply in base years to reap profits in non-base years, ultimately resulting in a suboptimal outcome in terms of social welfare. Combining the revenue cap with a price cap can improve welfare while requiring relatively little information: We demonstrate that a set of price caps exists such that a hybrid regulation consisting of any element in this set and the cost-based revenue cap unambiguously improves welfare and, under certain conditions, achieves the socially desirable outcome.