Regulatory Holidays and Optimal Network Expansion

TILEC Discussion Paper No. 2016-008

CentER Discussion Paper No. 2016-015

17 Pages Posted: 27 Apr 2016 Last revised: 3 Oct 2016

Bert Willems

Tilburg University - Department of Economics - CentER & TILEC

Gijsbert Zwart

University of Groningen

Date Written: April 18, 2016

Abstract

We model the optimal regulation of continuous, irreversible, capacity expansion, in a model in which the regulated network firm has private information about its capacity costs, investments need to be financed out of the firm's cash flows from selling network access and demand is stochastic. If asymmetric information is large, the optimal mechanism consists of a regulatory holiday for low-cost firms, and a mark-up regime for higher-cost firms. With the regulatory holiday, a firm receives the full revenue of capacity sales, and expands capacity as if it were an unregulated monopolist. Under the mark-up regime, a firm receives only a fraction of the capacity revenues, and is obliged to expand capacity whenever the price for capacity reaches a threshold. The regulatory holiday is necessary to fund information rents to the most efficient firms, which invest relatively early, as direct investment subsidies are not feasible.

Keywords: egulatory holiday, real option value, asymmetric information, optimal contract

JEL Classification: D81, D82, L51

Suggested Citation

Willems, Bert and Zwart, Gijsbert, Regulatory Holidays and Optimal Network Expansion (April 18, 2016). TILEC Discussion Paper No. 2016-008. Available at SSRN: https://ssrn.com/abstract=2770531 or http://dx.doi.org/10.2139/ssrn.2770531

Bert Willems

Tilburg University - Department of Economics - CentER & TILEC ( email )

P.O. Box 90153 Room K308
Tilburg, 5000LE
Netherlands
+31134662588 (Phone)

HOME PAGE: http://www.bertwillems.com

Gijsbert Zwart (Contact Author)

University of Groningen ( email )

P.O. Box 800
9700 AH Groningen
Netherlands

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