Setting the X Factor in Price-Cap Regulation Plans

Despite the popularity of price-cap regulation in practice, the economic literature provides limited guidance on how to determine the X factor, which is the rate at which inflation-adjusted output prices must fall under price-cap plans. We review the relevant basic principles, and then determine how to set the X factor: (1) when only a subset of the firm's products are subject to price-cap regulation, and when product-specific costs and productivity cannot be measured; (2) when changes in regulated prices affect the economy-wide inflation rate; and (3) in the presence of such structural changes as strengthened competitive forces.