A Sequential Mechanism for Direct Price Regulation

Abstract

In this article, we describe a mathematical model of price-cap regulation, in a simplified institutional setting. We show that, even in the presence of uncertainty as to the success of actions taken to improve productivity, and even in the presence of moral hazard, such a regulatory method can achieve its aim—namely, decreasing output prices and increasing productivity.¹ Thus we consider the problem faced by a regulator who wants to provide incentives for a firm to effect cost reductions—and hence price reductions—through technological change or by other means. We model the manager of the firm as facing constraints imposed by the shareholders and other providers of capital, by the customers, and by the regulator. The regulator’s ultimate objective is a secular real decrease in the firm’s prices. However, the manager’s private utility may not be maximized by activities that are maximally cost-reducing. Moreover, the regulator cannot directly observe all of the manager’s actions, the outcomes of which are also influenced by random exogenous events. Hence a problem of moral hazard arises.

A version of the ideas in the present article was published—without the mathematics—in the proceedings of an “Airlie House” conference that took place in 1982 (see Linhart, Radner, and Sinden, 1983). The term “price-cap” was not yet in use at that time.