Final answer:
Regulatory capture can lead to regulators inadequately representing consumer interests, which may result in practices that keep prices high and limit competition. Allocatively efficient pricing becomes complex when firms being regulated heavily influence the regulations. Price cap regulation aims to incentivize efficiency and innovation by allowing natural monopolies to experience profits or losses instead of guaranteeing a rate of profit.
Step-by-step explanation:
The allocatively efficient price can create a dilemma for regulators due to the phenomenon known as regulatory capture. This occurs when the firms that are meant to be regulated influence the regulations to their advantage. When regulators set prices, they might opt for a solution that appears to benefit both consumers and the social interest, which is often where the marginal cost meets the demand curve. An example would be setting a price at the point where marginal cost and demand intersect, often producing a higher quantity and lower price than what monopoly conditions would set. However, regulatory capture may lead to regulators poorly representing consumers, enabling existing competitors to work together to limit competition, reduce output, and keep prices high. Efficiency and innovation incentives can be built into price cap regulation by allowing the potential for higher profits or losses rather than a fixed profit rate with cost-plus regulation.