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What is a Price Cap?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 18 November 2016
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A price cap is simply a process for establishing rates or prices that will be charged for a particular good or service. In some instances, there are governmental organizations that determine price regulation. One example is in the rates that may be charged for household utilities, such as water and electricity.

Often, there is a regional or state-level agency that is charged with the task of working with utility providers to determine a price cap for services rendered that is equitable to the consumer as well as to the supplier. Increases in rates have to meet with the approval of the state agency before the utility can implement any price changes that exceed the agreed upon limit.

In other settings, a price cap may be arrived by paying attention to the common economic indicators of supply and demand. As an example, an industry may choose to impose one for manufactured goods that will meet the demand but will not create a situation that will price anyone out of business. At the same time, a cap does allow for a degree of competitive pricing, so players in the industry retain the ability to distinguish themselves by both quality and price to the available consumer market.

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There are a lot of advantages to implementing a price cap, above and beyond making sure the general public can afford basic services and goods. First, revenue-cap regulation establishes a fair balance between profit making and covering operation expenses. It can ensure that the provider makes enough profit to continue delivering services, but it does not allow the company to make an unreasonable amount of profit per consumer. This means that the provider has to look for ways to keep the operation efficient. A number of innovations on the production of goods and services have come about because suppliers had to find new ways to deliver more goods to a larger audience without increasing the price tag.

Second, the cap helps to set reasonable expectations as to what the general public should pay for services rendered. Generally, government agencies and public service commissions release details that are available to the average citizen about what it costs a utility to deliver its service. Understanding how much of the average dollar per usage actually goes into providing the service can help people understand why the current prices need to be revised, or why they should be allowed to stand. While no one likes to pay more for services, this form of regulation often makes it clear what the associated costs of that service are, which can make a price hike a little easier to deal with.

One of the key indicators used to arrive at or revise a price cap is the rate of inflation. Just as individuals are affected by inflation, so are service providers. Often, government agencies will agree with providers that an upward change in the cap is needed, so the vendors can continue to make enough profit to adequately provide services to consumers. While this may seem unfair to some consumers, people should remember that the alternative could easily be cutting back on service delivery in order to remain profitable. A realistic price helps to maintain a balance between what the consumer can afford to pay and what the providers needs to deliver the service and still realize a profit.

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anon945085
Post 8

This article covers more common stuff. If you put a cap on more, like say housing and agriculture, that cap will allow for more money spent, which means more received and more taxes paid, and when the consumer sees it so does everyone else.

Lets take rent: $600 for one bed is outrageous. $200 is better. Now think how those savings play into everything else.

Calmiker
Post 7

Economists tell us that prices set by supply and demand in a free market economy are far and away the most efficient and effective way to allocate scarce resources. The use of price caps for utilities is warranted because there is no free market for utilities. It would be cost-prohibitive for multiple competitors to all run electrical, gas or sewage lines to the homes and offices of each potential customer. So governments authorize utility monopolies and then establish price caps to prevent exploitation of consumers. But for anything that trades in a free market, price caps are highly costly and inefficient.

Many foreign countries have set price caps on drugs and U.S. citizens have suggested that we do the

same. Their simple-minded justification is that drugs can be critical to saving lives and therefore should be as affordable as possible.

It’s a problem because the gross margin on a single pill must include not just the cost of production but also the (average) ten year development cost, the failures that never got approved, the potential costs of liability and recalls, a fair profit in return for a very risky investment, etc. Foreign countries’ price caps are often based only on the cost of a pill’s production. So while the drug maker can make a profit by selling it at that price, the drug will never pay for the cost of development, etc., unless a higher price can be found in some other market. And that market is the U.S. Countries with price caps get a free ride while U.S. patients get stuck with higher drug prices required for drug development. This is something the WTO should investigate as an unfair competitive practice.

If, instead, the U.S. adopted price caps on drugs, we would find that a) the worldwide development of new drugs would begin to dry up and/or b) price caps would have to be set to cover development costs in all countries, increasing costs overseas. This latter option is highly problematic given the extensive risk factors facing the drug manufacturer.

Sunny27
Post 3

Latte31- I agree with you. Businesses take on risk when starting a new venture. Sometimes the risk pays off in increased profits and sometimes it does not.

I think the market should determine what the price of something should be. The government should not decide what something should cost.

For example, if the cost of something becomes too high, consumers might choose not to purchase the item.

If enough of the demand drops eventually the price of the item will come down. This is how the market determines appropriate pricing. This is far better than imposing a price cap.

latte31
Post 2

Oasis11- While I agree that there should be a price cap regarding utility services, I disagree that the government should be restricting a company's profits in other industries.

In a capitalist society, successful businesses that are efficiently run are rewarded with profits. These profits should not be limited to what the government feels is appropriate.

The more profit the company has more taxes they generally pay and when a company is profitable it generally provides better goods and services.

oasis11
Post 1

Price caps generally are imposed on industries or companies that usually are main providers of vital goods and services.

A classic example of this involves the utility companies because the utility company is the name service provider of power to consumers in a given area. Government regulations state that the government must approve any price increase in services.

This is to ensure that the power company does not take an advantage its customers because they are the sole provider of the power source. Since there are no other providers for electrical power the government imposes a price cap for services.

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