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Regulatory Risk under Optimal Incentive Regulation

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  • Roland Strausz

Abstract

The paper provides a tractable, analytical framework to study regulatory risk. Regulatory risk is captured by uncertainty about the policy variables in the regulator’s objective function: weights attached to profits and costs of public funds. Results are as follows: 1) The regulator’s reaction to regulatory risk depends on the curvature of aggregate demand. 2) It yields a positive information rent effect exactly when demand is convex. 3) Firms benefit from regulatory risk exactly when demand is convex. 4) Consumers’ risk preferences tend to contradict the firm’s. 5) Benevolent regulators always prefer regulatory risk and these preferences may contradict both the firm’s and consumers’.

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Bibliographic Info

Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 2638.

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Date of creation: 2009
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Handle: RePEc:ces:ceswps:_2638

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Keywords: optimal incentive regulation; regulatory risk; benevolent regulators; information rents;

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References

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  1. Armstrong, Mark & Sappington, David E.M., 2007. "Recent Developments in the Theory of Regulation," Handbook of Industrial Organization, Elsevier, Elsevier.
  2. Roland Strausz, . "Deterministic versus Stochastic Mechanisms in Principal--Agent Models," Papers, Departmental Working Papers 020, Departmental Working Papers.
  3. Richard J. Gilbert & David M. Newbery, 1994. "The Dynamic Efficiency of Regulatory Constitutions," RAND Journal of Economics, The RAND Corporation, vol. 25(4), pages 538-554, Winter.
  4. Laffont, Jean-Jacques & Tirole, Jean, 1986. "Using Cost Observation to Regulate Firms," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 94(3), pages 614-41, June.
  5. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, Elsevier, vol. 2(3), pages 225-243, September.
  6. Thomas P. Lyon, 1991. "Regulation with 20-20 Hindsight: "Heads I Win, Tails You Lose"?," RAND Journal of Economics, The RAND Corporation, vol. 22(4), pages 581-595, Winter.
  7. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, American Economic Association, vol. 73(1), pages 228-33, March.
  8. David J. Salant & Glenn A. Woroch, 1992. "Trigger Price Regulation," RAND Journal of Economics, The RAND Corporation, vol. 23(1), pages 29-51, Spring.
  9. Laffont, Jean-Jacques & Tirole, Jean, 1988. "The Dynamics of Incentive Contracts," Econometrica, Econometric Society, Econometric Society, vol. 56(5), pages 1153-75, September.
  10. Pindyck, Robert S., 1986. "Irreversible investment, capacity choice, and the value of the firm," Working papers, Massachusetts Institute of Technology (MIT), Sloan School of Management 1802-86., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  11. Laffont, Jean-Jacques & Tirole, Jean, 1990. "Adverse Selection and Renegotiation in Procurement," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 57(4), pages 597-625, October.
  12. Kimball, Miles S, 1990. "Precautionary Saving in the Small and in the Large," Econometrica, Econometric Society, Econometric Society, vol. 58(1), pages 53-73, January.
  13. Samuelson, Paul A, 1972. "The Consumer Does Benefit From Feasible Price Stability," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 86(3), pages 476-93, August.
  14. Paolo M. Panteghini & Carlo Scarpa, 2003. "Irreversible Investments and Regulatory Risk," CESifo Working Paper Series 934, CESifo Group Munich.
  15. Kolbe, A Lawrence & Tye, William B, 1996. "Compensation for the risk of stranded costs," Energy Policy, Elsevier, Elsevier, vol. 24(12), pages 1025-1050, December.
  16. Hartman, Richard, 1972. "The effects of price and cost uncertainty on investment," Journal of Economic Theory, Elsevier, Elsevier, vol. 5(2), pages 258-266, October.
  17. Thomas P. Lyon & John W. Mayo, 2005. "Regulatory Opportunism and Investment Behavior: Evidence from the U.S. Electric Utility Industry," RAND Journal of Economics, The RAND Corporation, vol. 36(3), pages 628-644, Autumn.
  18. Chang, Mo Ahn & Thompson, Howard E, 1989. "An Analysis of Some Aspects of Regulatory Risk and the Required Rate of Return for Public Utilities," Journal of Regulatory Economics, Springer, Springer, vol. 1(3), pages 241-57, September.
  19. Auriol, Emmanuelle & Warlters, Michael, 2007. "The Marginal Cost of Public Funds in Developing Countries: An Application to 38 African Countries," IDEI Working Papers, Institut d'Économie Industrielle (IDEI), Toulouse 371, Institut d'Économie Industrielle (IDEI), Toulouse.
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Citations

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Cited by:
  1. Michael Funke & Marc Gronwald, 2009. "A Convex Hull Approach to Counterfactual Analysis of Trade Openness and Growth," CESifo Working Paper Series 2692, CESifo Group Munich.
  2. Roland Strausz, 2010. "The Political Economy of Regulatory Risk," CESifo Working Paper Series 2953, CESifo Group Munich.
  3. Michał Grajek & Lars-Hendrik Röller, 2009. "Regulation and Investment in Network Industries: Evidence from European Telecoms," SFB 649 Discussion Papers SFB649DP2009-039, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  4. Barbara Choroś & Wolfgang Härdle & Ostap Okhrin, 2009. "CDO and HAC," SFB 649 Discussion Papers SFB649DP2009-038, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  5. Maria Grith & Wolfgang Härdle & Juhyun Park, 2009. "Shape invariant modelling pricing kernels and risk aversion," SFB 649 Discussion Papers SFB649DP2009-041, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.

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