Abstract
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.
Similar content being viewed by others
References
M. Asplund (2000) ArticleTitleWhat fraction of a capital investment is sunk costs? Journal of Industrial Economics 48 IssueID3 287–304
T.R. Beard D.L. Kaserman J.W. Mayo (2003) ArticleTitleRegulation, competition, and the optimal recovery of stranded costs International Journal of Industrial Organization 21 IssueID6 831–848 Occurrence Handle10.1016/S0167-7187(03)00034-1
G. Biglaiser M. Riordan (2000) ArticleTitleDynamics of price regulation RAND Journal of Economics 31 IssueID4 744–767
M.J. Brennan E.S. Schwartz (1982a) ArticleTitleConsistent regulatory policy under uncertainty Bell Journal of Economics 13 IssueID2 506–521
M.J. Brennan E.S. Schwartz (1982b) ArticleTitleRegulation and corporate investment policy Journal of Finance 37 IssueID2 289–300
S. Cowan (2003) ArticleTitleOptimal risk allocation for regulated monopolies and consumers Journal of Public Economics 88 285–303
A.K. Dixit (1993) The art of smooth pasting Harwood Academic Publishers Amsterdam
A.K. Dixit R.S. Pindyck (1994) Investment under uncertainty Princeton University Press Princeton
I.M. Dobbs (2004) ArticleTitleIntertemporal price cap regulation under uncertainty Economic Journal 114 421–440 Occurrence Handle10.1111/j.1468-0297.2004.00215.x
N. Economides (1999) Real options and the costs of the local telecommunications network J. Alleman E. Noam (Eds) The new investment theory of real options and its implications for the cost models in telecommunications Kluwer Academic Publishers Boston, MA
L.T. Evans G.A. Guthrie (2005) ArticleTitleRisk, price regulation, and irreversible investment International Journal of Industrial Organization 23 109–128 Occurrence Handle10.1016/j.ijindorg.2004.11.005
D. Fudenberg J. Tirole (1991) Game theory MIT Press Cambridge, MA
J. Hausman (1999) The effect of sunk costs in telecommunications regulation J. Alleman E. Noam (Eds) The new investment theory of real options and its implications for telecommunications Economics Kluwer Academic Publishers Boston, MA
J. Hausman S. Myers (2002) ArticleTitleRegulating the United States railroads: The effects of sunk costs and asymmetric risk Journal of Regulatory Economics 22 IssueID3 287–310 Occurrence Handle10.1023/A:1020822228646
D.J. Johnstone (2003) ArticleTitleReplacement cost asset valuation and regulation of energy infrastructure tariffs Abacus 39 IssueID1 1–41 Occurrence Handle10.1111/1467-6281.00118
A.L. Kolbe L.S. Borucki (1998) ArticleTitleThe impact of stranded-cost risk on required rates of return for electric utilities: Theory and an example Journal of Regulatory Economics 13 255–275 Occurrence Handle10.1023/A:1008081104532
J-J. Laffont J. Tirole (1993) A theory of incentives in procurement and regulation MIT Press Cambridge, MA
H.E. Leland (1974) ArticleTitleRegulation of natural monopolies and the fair rate of return Bell Journal of Economics and Management Science 5 IssueID1 3–15
S. Littlechild (2003) ArticleTitleReflections on incentive regulation Review of Network Economics 2 IssueID4 289–315
M. Loeb W. Magat (1979) ArticleTitleA decentralized method of utility regulation Journal of Law and Economics 22 399–404 Occurrence Handle10.1086/466949
D.M. Mandy W.W. Sharkey (2003) ArticleTitleDynamic pricing and investment from static proxy models Review of Network Economics 2 IssueID4 403–439
W.J. Marshall J.B. Yawitz E. Greenberg (1981) ArticleTitleOptimal regulation under uncertainty Journal of Finance 36 IssueID4 909–921
D.M. Newbery (1999) Privatisation, restructuring, and regulation of network utilities MIT Press Cambridge, MA
Pindyck, R.S. (2003). Mandatory unbundling and irreversible investment in telecom networks. NBER Working Paper No. W10287.
V.A. Ramey M.D. Shapiro (2001) ArticleTitleDisplaced capital: A study of aerospace plant closings Journal of Political Economy 109 IssueID5 958–992 Occurrence Handle10.1086/322828
M.A. Salinger (1998) ArticleTitleRegulating prices to equal forward-looking costs: Cost-based prices or price-based costs? Journal of Regulatory Economics 14 149–163 Occurrence Handle10.1023/A:1008057218273
D.E.M. Sappington (2002) Price regulation M.E. Cave S.K. Majumdar I. Vogelsang (Eds) Handbook of Telecommunications Economics Elsevier/North Holland Amsterdam
D.L. Weisman (2002) ArticleTitleDid the high court reach an economic low in Verizon v. FCC? Review of Network Economics 1 IssueID2 90–105
Author information
Authors and Affiliations
Corresponding author
Rights and permissions
About this article
Cite this article
Evans, L., Guthrie, G. Incentive Regulation of Prices When Costs are Sunk. J Regul Econ 29, 239–264 (2006). https://doi.org/10.1007/s11149-006-7398-0
Issue Date:
DOI: https://doi.org/10.1007/s11149-006-7398-0