regulator sets a price that the firm can charge over the next few years. A common pattern was to require a price

that declined slightly over time. If the firm can find ways of reducing its costs more quickly than the price caps,

it can make a high level of profits. However, if the firm cannot keep up with the price caps or suffers bad luck in

the market, it may suffer losses. A few years down the road, the regulators will then set a new series of price

caps based on the firm’s performance.

Price cap regulation requires delicacy. It will not work if the price regulators set the price cap unrealistically

low. It may not work if the market changes dramatically so that the firm is doomed to incurring losses no

matter what it does—say, if energy prices rise dramatically on world markets, then the company selling natural

gas or heating oil to homes may not be able to meet price caps that seemed reasonable a year or two ago.
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