Good Regulatory Lags for Price Cap and Rolling Cap contracts
AbstractPrice caps are a popular form of monopoly price regulation. One of its disadvantages is the perverse incentives that regulated firms might have to scamp on cost reducing effort during the last years before a price review. In order to avoid this problem a â€œrolling capâ€ contract was introduced in the United Kingdom that overcomes this last problem. In spite of their popularity, there is scant research on the optimal regulatory lag (number of years between price reviews) of a price cap or rolling cap contract. In practice, around the world most price cap or rolling cap contracts have a lag of 4 to 5 years, but this is not based on any optimality consideration. As is well known, the regulatory lag determines the power of an incentive contract and thus the incentives to undertake cost reducing effort. Schmalensee (1989) studied the optimal power of regulatory contracts in a static model with uncertainty and asymmetric information. She finds that medium powered contracts are generally superior to the polar cases of high or low powered contracts. In this paper, we extend Schmalensee (1989) model used to study the optimal power of regulatory contracts to a dynamic framework. We use numerical simulation to study the optimal regulatory lag for different combinations of demand and cost parameters under a particular linear quadratic structure. We find that in general a 2 year lag is optimal under both a price cap and rolling cap contracts and that a benevolent regulator prefers the rolling cap over the price cap contract in almost all the cases
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Date of creation: 11 Aug 2004
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Price Cap; Rolling Cap; Regulatory Lag; Dynamic Programming;
Find related papers by JEL classification:
- C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- L50 - Industrial Organization - - Regulation and Industrial Policy - - - General
- L52 - Industrial Organization - - Regulation and Industrial Policy - - - Industrial Policy; Sectoral Planning Methods
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-10-30 (All new papers)
- NEP-MIC-2004-10-30 (Microeconomics)
- NEP-REG-2004-10-30 (Regulation)
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