Incentive Compatible Regulation of Quality Provision by Natural Monopolies — The Role of Technical Progress

Abstract

This paper deals with the design of incentive compatible regulatory mechanisms for natural monopolies to provide for quality of service when quality cannot be observed by consumers and cost information is asymmetric. In particular, we are concerned with the creation of incentives for process innovations as a means to compensate for the quality induced price increase. Hence, the main focus of the analysis is on the relation between price, quality and R&D investment. The information structure is taken as asymmetric with respect to the firm’s productivity carrying over to the cost-raising impact of quality provision as well as the cost-reducing effect of R&D. First, we characterize optimal regulatory schemes for price and quality while investment of R&D is left under the control of the firm. Subsequently we consider the regulator to be able to monitor and regulate R&D, which improves welfare. For both models we find prices to be higher, quality and investment in R&D to be lower than in the first-best solution. However, in case of regulated technical progress quality is distorted less, though at the expense of productivity losses with R&D investment set below the level that the firm would achieve.