The primary factors that affect a company's price cap are part of an equation known as the price cap index. This formula determines the best balance among three factors: inflation, expected savings from efficiency efforts compared to comparable companies, and factors outside of the company’s control. The price determined from this information is meant to protect the customer from being overcharged while making it economically feasible for the company providing the service to stay in business.
Commonly know as PCI, the price cap index determines the highest possible price change allowed based on the combination of three factors. Each factor in the equation has a corresponding letter. There is an exogenous factor (Z), an inflation factor (I), and a productivity offset (x). These elements combined provide a comprehensive view of the company’s services as they compare to both the economy as a whole and a comparable industry.
The exogenous factor refers to elements outside of the company’s control that may affect its ability to do business. This can include events such as an economic recession or natural disasters. It may also be an unanticipated local or world event which the company could not have predicted. This factor is one of the most variable of the three. When faced with an unavoidable setback, the company will be allowed to raise prices, but how much depends upon the nature of the problem.
The inflation factor is determined based on current data about inflation in the economy. The primary basis for comparison is an average of the rates charged by similar companies in the same market. It takes into consideration both how an average company is faring and the current value of the country’s currency. If it is above average, then prices will go down; if it falls below the combined factors, prices will rise.
Productivity offset measures how well the company is able to save money with initiatives to increase efficiency. It also measures the success of these efforts as they compare to those of similar companies in the market. Both ongoing efforts to make improvements and current results are typically considered. If efficiency is higher, then the price of services must go down. The opposite should happen if it is lower.
Price cap regulation was first conceived of in the United Kingdom in the 1980s. Stephen Littlechild, an economist for the UK Treasury, devised the method to manage the prices of private utility companies. It was a departure from previous concepts in which revenue was the basis for determining price.
