Journal of Regulatory Economics

, Volume 29, Issue 3, pp 239–264 | Cite as

Incentive Regulation of Prices When Costs are Sunk

  • Lewis Evans
  • Graeme Guthrie
Original Article


We present a model featuring irreversible investment, economies of scale, uncertain future demand and capital prices, and a regulator who sets the firm’s output price according to the cost structure of a hypothetical replacement firm. We show that a replacement firm has a fundamental cost advantage over the regulated firm: it can better exploit the economies of scale because it has not had to confront the historical uncertainties faced by the regulated firm. We show that setting prices so low that a replacement firm is just willing to participate is insufficient to allow the regulated firm to expect to break even whenever it has to invest. Thus, unless the regulator is willing to incur costly monitoring to ensure the firm invests, revenue must be allowed in excess of that required for a replacement firm to participate. This contrasts with much of the existing literature, which argues that the market value of a regulated firm should equal the cost of replacing its existing assets. We also obtain a closed-form solution for the regulated firm’s output price when this price is set at discrete intervals. In contrast to rate of return regulation, we find that resetting the regulated price more frequently can increase the risk faced by the firm’s owners, and that this is reflected in a higher output price and a higher weighted-average cost of capital.


Incentive regulation Uncertainty Sunk costs Economies of scale 

JEL Classification

G31 L5 


Unable to display preview. Download preview PDF.

Unable to display preview. Download preview PDF.


  1. Asplund, M. 2000What fraction of a capital investment is sunk costs?Journal of Industrial Economics48287304Google Scholar
  2. Beard, T.R., Kaserman, D.L., Mayo, J.W. 2003Regulation, competition, and the optimal recovery of stranded costsInternational Journal of Industrial Organization21831848CrossRefGoogle Scholar
  3. Biglaiser, G., Riordan, M. 2000Dynamics of price regulationRAND Journal of Economics31744767Google Scholar
  4. Brennan, M.J., Schwartz, E.S. 1982aConsistent regulatory policy under uncertaintyBell Journal of Economics13506521Google Scholar
  5. Brennan, M.J., Schwartz, E.S. 1982bRegulation and corporate investment policyJournal of Finance37289300Google Scholar
  6. Cowan, S. 2003Optimal risk allocation for regulated monopolies and consumersJournal of Public Economics88285303Google Scholar
  7. Dixit, A.K. 1993The art of smooth pastingHarwood Academic PublishersAmsterdamFundamentals of Pure and Applied Economics 55Google Scholar
  8. Dixit, A.K., Pindyck, R.S. 1994Investment under uncertaintyPrinceton University PressPrincetonGoogle Scholar
  9. Dobbs, I.M. 2004Intertemporal price cap regulation under uncertaintyEconomic Journal114421440CrossRefGoogle Scholar
  10. Economides, N. 1999Real options and the costs of the local telecommunications networkAlleman, J.Noam, E. eds. The new investment theory of real options and its implications for the cost models in telecommunicationsKluwer Academic PublishersBoston, MAGoogle Scholar
  11. Evans, L.T., Guthrie, G.A. 2005Risk, price regulation, and irreversible investmentInternational Journal of Industrial Organization23109128CrossRefGoogle Scholar
  12. Fudenberg, D., Tirole, J. 1991Game theoryMIT PressCambridge, MAGoogle Scholar
  13. Hausman, J. 1999The effect of sunk costs in telecommunications regulationAlleman, J.Noam, E. eds. The new investment theory of real options and its implications for telecommunications EconomicsKluwer Academic PublishersBoston, MAGoogle Scholar
  14. Hausman, J., Myers, S. 2002Regulating the United States railroads: The effects of sunk costs and asymmetric riskJournal of Regulatory Economics22287310CrossRefGoogle Scholar
  15. Johnstone, D.J. 2003Replacement cost asset valuation and regulation of energy infrastructure tariffsAbacus39141CrossRefGoogle Scholar
  16. Kolbe, A.L., Borucki, L.S. 1998The impact of stranded-cost risk on required rates of return for electric utilities: Theory and an exampleJournal of Regulatory Economics13255275CrossRefGoogle Scholar
  17. Laffont, J-J., Tirole, J. 1993A theory of incentives in procurement and regulationMIT PressCambridge, MAGoogle Scholar
  18. Leland, H.E. 1974Regulation of natural monopolies and the fair rate of returnBell Journal of Economics and Management Science5315Google Scholar
  19. Littlechild, S. 2003Reflections on incentive regulationReview of Network Economics2289315Google Scholar
  20. Loeb, M., Magat, W. 1979A decentralized method of utility regulationJournal of Law and Economics22399404CrossRefGoogle Scholar
  21. Mandy, D.M., Sharkey, W.W. 2003Dynamic pricing and investment from static proxy modelsReview of Network Economics2403439Google Scholar
  22. Marshall, W.J., Yawitz, J.B., Greenberg, E. 1981Optimal regulation under uncertaintyJournal of Finance36909921Google Scholar
  23. Newbery, D.M. 1999Privatisation, restructuring, and regulation of network utilitiesMIT PressCambridge, MAGoogle Scholar
  24. Pindyck, R.S. (2003). Mandatory unbundling and irreversible investment in telecom networks. NBER Working Paper No. W10287.Google Scholar
  25. Ramey, V.A., Shapiro, M.D. 2001Displaced capital: A study of aerospace plant closingsJournal of Political Economy109958992CrossRefGoogle Scholar
  26. Salinger, M.A. 1998Regulating prices to equal forward-looking costs: Cost-based prices or price-based costs?Journal of Regulatory Economics14149163CrossRefGoogle Scholar
  27. Sappington, D.E.M. 2002Price regulationCave, M.E.Majumdar, S.K.Vogelsang, I. eds. Handbook of Telecommunications EconomicsElsevier/North HollandAmsterdamGoogle Scholar
  28. Weisman, D.L. 2002Did the high court reach an economic low in Verizon v. FCC?Review of Network Economics190105Google Scholar

Copyright information

© Springer Science+Business Media, Inc. 2006

Authors and Affiliations

  1. 1.School of Economics and FinanceNew Zealand Institute for the Study of Competition and Regulation, Victoria University of WellingtonWellingtonNew Zealand
  2. 2.School of Economics and FinanceVictoria University of WellingtonWellingtonNew Zealand

Personalised recommendations