Welfare Effects of Price Cap Regulation in comparison with Rate of Return Regulation: A Stochastic Frontier Analysis of Efficiency Costs of Flour Factories in Addis Ababa

Abstract

This study aims at assessing the welfare effect of Price Cap Regulation that put in order by the government to regulate and ensure price stability for basic commodities supply in the market. In order to achieve the stated objective of the study, Stochastic Frontier Analysis of Efficiency Costs model is specified using the Cobb-Douglass Specification in its stochastic form. The parameters of the stochastic frontier functions are estimated using maximum likelihood that help to analyze the welfare effects of Price Cap Regulation. The data used for the estimation includes panel of 28 wheat flour factories in Addis Ababa from the period of May 2011 to April 2015. The major findings of the study show that Price Cap Regulation has improved the welfare of consumers as compared to the Rate of Return regulation. However, welfare distribution problem remains unsolved. The average capacity utilization of the flour mills remain as low as a quarter of their capacity and the supply of input wheat, which constitute the major cost of production of wheat flour as addressed by the government, is found to be not satisfactory. To improve efficiency of flour mills and the corresponding consumer welfare, supply of wheat need to be improved both in quantity and frequency terms. Furthermore, welfare distribution problem need to be addressed by enforcing the incentive scheme of flour mills based on the average not on the high cost firm. The study is made on the four year panel data of twenty eight flour factories situated in Addis Ababa. Such data helps to make comparative welfare effects in the study area, and to complement it, further research considering the regional flour mills and quality impact of price cap regulation can help to produce full effect assessment.