Firm Regulation and Profit-Sharing: A Real Option Approach
AbstractTo avoid high profit levels often experienced in countries where monopolies in public utility sectors are regulated through price-cap mechanisms, several regulatory agencies have recently introduced profit-sharing (PS) clauses aimed at obtaining price reductions to the benefit of consumers. However, the implementation of these PS clauses has often turned out to be severely con- trained by the incompleteness of the price-cap itself and the non-verifiability of firms’profits. This paper studies the properties of a second-best optimal PS mechanism designed by the regulator to induce the regulated monopolist to divert part of its profits to custormers. In a dynamic model where a reg- ulated monopolist manages a long-term franchise contract and the regulator has the option to revoke the contract if there are serious welfare losses, we first derive the welfare maximising PS mechanism under verifiability of prof- its. Subsequently, we explore the sustainability of the PS mechanism under non-verifiability of profits. In a infinite-horizon game, it is showed that the dynamic sustainability of the PS clause crucially depends upon the magni- tude of the regulator’s revocation cost: the higher this cost, the lower the profit shared and the less frequent the regulator’s PS introduction. Finally, we present the endogenous and dynamic price adjustment which follows the adoption of the investigated PS mechanism in a price-cap regulation setting.
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Bibliographic InfoPaper provided by Fondazione Eni Enrico Mattei in its series Working Papers with number 2006.7.
Date of creation: Jan 2006
Date of revision:
Price-cap regulation; Profit-sharing; Real options;
Other versions of this item:
- Moretto Michele & Valbonesi Paola, 2007. "Firm Regulation and Profit Sharing: A Real Option Approach," The B.E. Journal of Economic Analysis & Policy, De Gruyter, vol. 7(1), pages 1-34, November.
- Michele Moretto & Paola Valbonesi, 2007. "Firm Regulation and Profit-Sharing: A Real Option Approach," "Marco Fanno" Working Papers 0052, Dipartimento di Scienze Economiche "Marco Fanno".
- C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
- L33 - Industrial Organization - - Nonprofit Organizations and Public Enterprise - - - Comparison of Public and Private Enterprise and Nonprofit Institutions; Privatization; Contracting Out
- L5 - Industrial Organization - - Regulation and Industrial Policy
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-07-21 (All new papers)
- NEP-COM-2006-07-21 (Industrial Competition)
- NEP-REG-2006-07-21 (Regulation)
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