Price-Cap Regulation, Price Elasticity of Demand, And Quality of Service

Abstract

Price-cap regulation is aimed at limiting price increases by the significant market powers and prevent the decrease in consumer surplus. Therefore, studies on price-cap regulation have implicitly neglected the theoretical possibility that firms might lower their prices to increase revenue when the price elasticity of demand exceeds 1. Using Chunghwa Telecom (CHT), the largest mobile phone service provider in Taiwan, as a case study, we estimated the price elasticity of residual demand faced by CHT and found that it was higher than 1. Therefore, CHT’s continual lowering of price, which improved its revenues during 2010–2013, was reasonable. Because telecommunication service providers are characterized by high fixed costs and low variable costs, these firms have the incentive to increase revenue and subsequently maximize their profit. However, lowering the prices attracts more subscribers while the capacity remains unchanged, thereby congesting communication channels and reducing service quality. For public utility regulators, our results reiterate that price-cap regulation should be combined with quality control, particularly when the price elasticity of demand exceeds 1.