Dynamically-Efficient Incentive Regulation: Application of the Bad News Principle

29 Pages Posted: 27 Feb 2003

See all articles by Lewis T. Evans

Lewis T. Evans

Victoria University of Wellington - New Zealand Institute for Study of Competition and Regulation Inc. (ISCR)

Graeme Guthrie

Victoria University of Wellington - School of Economics & Finance

Date Written: October 16, 2002

Abstract

Incentive regulation allows decentralised decision-making under regulatory parameters set on the basis of industry characteristics. When there is uncertainty, sunk costs, and flexibility in the timing of investment a monopoly will invest later than is socially desirable because it garners only a fraction of the benefits. This study considers the design of regulatory profit caps based on a measure of cost, either historical or replacement cost, to which a regulatory rate of return is applied. It demonstrates that the sources and extent of supply and demand uncertainties, and thereby characteristics of the industry, determine whether historical or replacement cost regulation is desirable. The welfare optimising level of the regulatory rate of return differs between historical and replacement cost regulation, this return is generally higher than the weighted average cost of capital, and welfare is degraded much more if it is set below, as opposed to above, the optimal regulatory return.

Keywords: Uncertainty, Sunk Costs, Incentive Regulation

JEL Classification: G18, G31, L5

Suggested Citation

Evans, Lewis T. and Guthrie, Graeme, Dynamically-Efficient Incentive Regulation: Application of the Bad News Principle (October 16, 2002). Available at SSRN: https://ssrn.com/abstract=361481 or http://dx.doi.org/10.2139/ssrn.361481

Lewis T. Evans (Contact Author)

Victoria University of Wellington - New Zealand Institute for Study of Competition and Regulation Inc. (ISCR) ( email )

Wellington 6001
New Zealand
64 4 4635562 (Phone)
64 4 4635566 (Fax)

Graeme Guthrie

Victoria University of Wellington - School of Economics & Finance ( email )

P.O. Box 600
Wellington 6140
New Zealand
64 4 463 5763 (Phone)

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