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Firm Regulation and Profit-Sharing: A Real Option Approach

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  • Michele Moretto

    (University of Brescia)

  • Paola Valbonese

    (University of Padova)

Abstract

To 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 Info

Paper provided by Fondazione Eni Enrico Mattei in its series Working Papers with number 2006.7.

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Date of creation: Jan 2006
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Handle: RePEc:fem:femwpa:2006.7

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Keywords: Price-cap regulation; Profit-sharing; Real options;

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References

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  1. Lyon, T.P., 1993. "A Model of Sliding-Scale Regulation," Papers 93-011, Indiana - Center for Econometric Model Research.
  2. Klein, Daniel B. & O'Flaherty, Brendan, 1993. "A game-theoretic rendering of promises and threats," Journal of Economic Behavior & Organization, Elsevier, vol. 21(3), pages 295-314, August.
  3. Bergin, James & MacLeod, W Bentley, 1993. "Continuous Time Repeated Games," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 34(1), pages 21-37, February.
  4. Michele Moretto & Paolo Panteghini & Carlo Scarpa, 2003. "Investment Size and Firm's Value under Profit Sharing Regulation," CESifo Working Paper Series 1040, CESifo Group Munich.
  5. Bawa, Vijay S & Sibley, David S, 1980. "Dynamic Behavior of a Firm Subject to Stochastic Regulatory Review," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 21(3), pages 627-42, October.
  6. Crew, Michael A & Kleindorfer, Paul R, 1996. "Incentive Regulation in the United Kingdom and the United States: Some Lessons," Journal of Regulatory Economics, Springer, vol. 9(3), pages 211-25, May.
  7. Leo K. Simon and Maxwell B. Stinchcombe., 1987. "Extensive Form Games in Continuous Time: Pure Strategies," Economics Working Papers 8746, University of California at Berkeley.
  8. Sappington, David E. M. & Weisman, Dennis L., 1996. "Revenue sharing in incentive regulation plans," Information Economics and Policy, Elsevier, vol. 8(3), pages 229-248, September.
  9. Mark Armstrong & Simon Cowan & John Vickers, 1994. "Regulatory Reform: Economic Analysis and British Experience," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262510790, December.
  10. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
  11. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
  12. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
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Cited by:
  1. Chiara D'Alpaos & Michele Moretto & Paola Valbonesi & Sergio Vergalli, 2009. "It is never too late: Optimal penalty for investment delay in public procurement contracts," Working Papers 0907, University of Brescia, Department of Economics.
  2. Chiara D'Alpaos & Michele Moretto & Paola Valbonesi, 2008. "Optimal penalty for investment delay in public procurement contracts," "Marco Fanno" Working Papers 0074, Dipartimento di Scienze Economiche "Marco Fanno".

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