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Regulation with 20-20 Hindsight: "Heads I Win, Tails You Lose"?

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  • Thomas P. Lyon

Abstract

Regulators are commonly accused of using 20-20 hindsight to punish a firm for bad outcomes rather than bad decisions; it is often thought that such penalties lead to underinvestment by the firm. I find that this expectation is not borne out when retrospective review is based on the firm's avoided costs. In a Joskow-type model, hindsight review mitigates the firm's tendency to build oversized risky projects, moving the firm closer to the cost-minimizing level of investment. In a rate-of-return model, the firm's allowed rate of return may have to be increased to keep expected profits nonnegative. If this is done, hindsight review does not affect the firm's investment level, but it does correct the (risk-neutral) firm's tendency to pay an excessive premium to eliminate construction cost uncertainty.

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Bibliographic Info

Article provided by The RAND Corporation in its journal RAND Journal of Economics.

Volume (Year): 22 (1991)
Issue (Month): 4 (Winter)
Pages: 581-595

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Handle: RePEc:rje:randje:v:22:y:1991:i:winter:p:581-595

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Cited by:
  1. Matthew Barmack & Edward Kahn & Susan Tierney, 2007. "A cost-benefit assessment of wholesale electricity restructuring and competition in New England," Journal of Regulatory Economics, Springer, vol. 31(2), pages 151-184, April.
  2. Larry Blank & John Mayo, 2009. "Endogenous Regulatory Constraints and the Emergence of Hybrid Regulation," Review of Industrial Organization, Springer, vol. 35(3), pages 233-255, November.
  3. Stratford Douglas & Thomas A. Garrett & Russell M. Rhine, 2009. "Disallowances and overcapitalization in the U.S. electric utility industry," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 23-32.
  4. Roland Strausz, 2009. "Regulatory Risk under Optimal Incentive Regulation," SFB 649 Discussion Papers SFB649DP2009-006, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  5. Kumkar, Lars, 2001. "Strommarktliberalisierung in Kalifornien: Schlägt das Pendel zurück?," Kiel Discussion Papers 378/379, Kiel Institute for the World Economy (IfW).

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