Journal of Regulatory Economics

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

Incentive Regulation of Prices When Costs are Sunk

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 


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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

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