Delegation and the Under-Investment Problem
Regulation Initiative Working Paper No. 32
Posted: 23 Sep 2002
Date Written: August 1999
This paper addresses a long-standing problem in regulation: underinvestment arising from the regulator's incentive to exploit the sunk cost nature of the regulated firm's captial investment. A number of ways of alleviating the problem are suggested in the literature including the establishment of a commitment mechanism in the form of a legal or constitutional guarantee of a 'fair' rate of return (Greenwald, 1984) a trigger-strategy equilibrium appropriate when the firm and regulator meet repeatedly over a long period (Salant & Woroch 1992) and regulatory capture under asymmetric information (Laffont and Tirole 1993 chapter 11 and a review exercise). In this paper a new solution to this problem is provided in the simplest possible context.
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