Answer to Question 1
In regulating a natural monopoly, a price cap regulation is a price ceiling in which a rule specifies the highest price that the firm is allowed to charge. A price cap lowers the price and increases output. This type of regulation gives a firm an incentive to operate efficiently and to keep its costs under control. In a competitive market, a price ceiling establishes the highest price that all firms in the market are allowed to charge. But the major issue is that in a competitive market, the competitive equilibrium already is efficient. And, to be effective, the price ceiling needs to be below the market equilibrium price. A shortage of the good occurs because firms are willing to supply less output than they would produce in the absence of the price ceiling. As a result, inefficiency is created.
Answer to Question 2
Price cap regulation is intended to motivate the firm to operate efficiently and keep its costs under control. It does so setting the maximum price the company can charge and then allowing the firm to keep part (or perhaps all) of any economic profit it can make if it cuts its costs.
A hypothetical example of the bottleneck effect.
Natural Settings
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