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Incentive Regulation of Prices When Costs are Sunk


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  • Lewis Evans


  • Graeme Guthrie



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. Copyright Springer Science+Business Media, Inc. 2006

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Bibliographic Info

Article provided by Springer in its journal Journal of Regulatory Economics.

Volume (Year): 29 (2006)
Issue (Month): 3 (05)
Pages: 239-264

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Handle: RePEc:kap:regeco:v:29:y:2006:i:3:p:239-264

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Related research

Keywords: Incentive regulation; Uncertainty; Sunk costs; Economies of scale; G31; L5;

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Cited by:
  1. Lewis Evans & Greame Guthrie & Andrea Lu, 2010. "A New Zealand Electricity Market Model: Assessment of the Effect of Climate Change on Electricity Production and Consumption," Working Papers 10_09, Motu Economic and Public Policy Research.
  2. Ian Dobbs, 2011. "Modeling welfare loss asymmetries arising from uncertainty in the regulatory cost of finance," Journal of Regulatory Economics, Springer, vol. 39(1), pages 1-28, February.
  3. Ingo Vogelsang, 2013. "The Endgame of Telecommunications Policy? A Survey," CESifo Working Paper Series 4545, CESifo Group Munich.
  4. Ingo Vogelsang, 2010. "Incentive Regulation, Investments and Technological Change," CESifo Working Paper Series 2964, CESifo Group Munich.
  5. Jean-Michel Glachant & Haikel Khalfallah & Yannick Perez & Vincent Rious & Marcelo Saguan, 2013. "Implementing incentive regulation through an alignment with resource bounded regulators," Post-Print halshs-00767872, HAL.
  6. Graeme Guthrie, 2006. "Regulating Infrastructure: The Impact on Risk and Investment," Journal of Economic Literature, American Economic Association, vol. 44(4), pages 925-972, December.
  7. Jean-Michel Glachant, Haikel Khalfallah, Yannick Perez, Vincent Rious and Marcelo Saguan, 2012. "Implementing Incentive Regulation and Regulatory Alignment with Resource Bounded Regulators," RSCAS Working Papers 2012/31, European University Institute.
  8. repec:reg:wpaper:606 is not listed on IDEAS
  9. Moutinho, Victor & Moreira, António C. & Mota, Jorge, 2014. "Do regulatory mechanisms promote competition and mitigate market power? Evidence from Spanish electricity market," Energy Policy, Elsevier, vol. 68(C), pages 403-412.


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