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Diversification incentives under “price-based” and “cost-based” regulation. Ronald R. Braeutigam John C. Panzar. The Phenomenon: More and more firms participate in both regulated (monopoly) and unregulated (highly competitive) markets. Dilemma for policy maker:
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Diversification incentives under “price-based” and “cost-based” regulation Ronald R. Braeutigam John C. Panzar
The Phenomenon: More and more firms participate in both regulated (monopoly) and unregulated (highly competitive) markets. • Dilemma for policy maker: Firm might utilize its position in the regulated market to “cross subsidize” its competitive venture. A blanket prohibition on participation in both types of markets may reduce social welfare.
How regulation in the monopoly market affects the behavior of the firm in the competitive market? Two forms of regulation • Cost-based • Price-based
General information A regulated firm serving two markets Firm’s cost function:
Cost-based Regulation Regulatory Constraint Firms profit Lagrangian form
Cost-based Regulation/Choice of output levels Proposition 1. (Pareto inefficiency). The profit-maximizing firm operating under rate-of-return regulation is Pareto inefficient. Given any observed level of the core service, the firm chooses an inefficiently low level of the noncore service. A Pareto-superior set of outputs could be obtained by increasing either the level of the noncore service or the levels of both services.
Cost-based Regulation/Choice of technology Proposition 2. (Choice of technology). The profit-maximizing firm operating under a binding rate-of-return constraint may choose an inefficient level of common facilities. It will overinvest (underinvest) in common facilities if, at the margin, the cost reductions such facilities yield for the core service are less than (greater than) the common costs allocated to the core service.
Cost-based Regulation/Incentives for cost-reducing innovation • Let be the dollar expenditures of the firm in attempting to reduce the costs respectively. • Then • Firm’s profit
Cost-based Regulation/Incentives for cost-reducing innovation Case 1. None of the costs of innovation are allowed in the revenue requirement of the core service. Constraint Thus the firm would innovate in the noncore market Underinvest in innovation in both common costs and in the core market
Cost-based Regulation/Incentives for cost-reducing innovation Case 2. All costs of innovation are allowed in the revenue requirement and treated as common costs. Constraint Thus the firm would innovate in common costs Overinvest in innovation in the noncore market Underinvest in the core market
Cost-based Regulation/Incentives for cost-reducing innovation Case 3. All costs of innovation are allowed in the revenue requirement and treated as costs to the core service. Constraint Thus the firm would innovate in the core market Overinvest in both common costs and the noncore market
Cost-based Regulation/Incentives for cost-reducing innovation Case 4. Regulator can distinguish between innovative costs and allocate them properly Constraint Thus the firm would innovate in each area No overinvestment or underinvestment takes place
Cost-based Regulation/Incentives for cost-reducing innovation Proposition 3. (Cost reducing innovation). If costs of innovation are treated homogeneously, the levels of innovative effort will generally not be efficient, leading either to underinvestment, overinvestment, or both. If the regulator attempts to allocate expenditures on cost-reducing effort, it will have to deal with the incentive the firm will have to characterize such costs as attributable to the core service wherever possible.
Cost-based Regulation/Pricing below marginal cost Add a third market to the model Profit and Constraint would be Proposition 4. (Price below marginal cost). If the regulated firm’s activities in a competitive market are included in the rate-of-return constraint, the firm will have an incentive to overproduce; market price will be below marginal cost in such a market
Price-based Regulation Advantages • The firm has no incentive to waste • Incentives to misreport cost allocations and choose an inefficient technology simply disappear • The firm will also have the same incentive to undertake cost-reducing innovation as an unregulated firm • The firm will produce in the noncore market up to the point at which marginal cost equals price
Price-based Regulation Problems • The desirable efficiency properties of price-cap regulation may not be easily realized under imperfect information. • How will the price cap be adjusted over time? • Can the regulator credibly precommit to a system of price-cap regulation? • In the present model there is only one core service whose price must be capped. In practice, there are likely to be a large number of such markets.
Conclusion • There have been many difficulties with rate-of return regulation (cost-based regulation). • As an alternative, price-cap regulation (price-based regulation) offers significant potential advantages. • Price-cap regulation in practice will not perform as well as it does in a static complete information model with only one core service.
