The regulation of a monopoly is sometimes based on the rate of returnthat it earns on its capital. The regulatory agency determines an allowed price, so that this rate of return is in some sense “competitive” or “fair.”
Although it is a key element in determining the firm’s rate of return, a firm’s capital stock is difficult to value. While a “fair” rate of return must be based on the firm’s actual cost of capital, that cost depends in turn on the behavior of the regulatory agency. Regulatory lag is a term associated with delays in changing regulated prices.
Another approach to regulation is setting price caps based on the firm’s variable costs. A price cap can allow for more flexibility than rate-of-return regulation. Under price cap regulation, for example, a firm would typically be allowed to raise its prices each year (without having to get approval from the regulatory agency) by an amount equal to the actual rate of inflation, minus expected productivity growth.