We consider the problem of a regulator who cannot observe the R&D expenditures of a firm devoted to reductions in the costs of production. It is shown for a finite horizon model that price-cap regulation does not only provide stronger incentives for cost reductions than does rate of return regulation, but that it is also capable of achieving a higher social welfare level, even if the costs of reviewing the current production costs are negligible. These conclusions are reinforced in an infinite horizon model.