Cost Padding in Regulated Monopolies
AbstractIn this paper we consider a regulated monopoly that can pad its costs to increase its cost reimbursement. Even while padding is ineácient the optimal incentive scheme tolerates some padding of costs to reduce the information rents paid to low cost types. It is shown that high cost firms pad costs more than low cost ßrms. We also show that cost padding moves pricing away from Ramsay optimal pricing toward more monopolistic pricing rules. We show that when auditing of total costs is costly, low cost firms face a fixed price contract and engage in no cost padding. High cost ßrms do less well but do engage in padding to increase the verified cost. If padded costs can be audited at some cost, low cost types engage in cost padding but high cost types do not. We also endogenize the distribution of cost types by allowing firms to engage in a pre-contractual, non-observable or verißable cost-reducing investment. The firm adopts a mixed strategy and this determines the distribution of cost types at the contracting stage. An example is given to show how the equilibrium distribution is computed.
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Bibliographic InfoPaper provided by Department of Economics, Keele University in its series Keele Department of Economics Discussion Papers (1995-2001) with number 2001/07.
Length: 33 pages
Date of creation: Mar 2001
Date of revision: Nov 2001
Publication status: Published in
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Postal: Department of Economics, Keele University, Keele, Staffordshire ST5 5BG - United Kingdom
Other versions of this item:
- D8 - Microeconomics - - Information, Knowledge, and Uncertainty
- L2 - Industrial Organization - - Firm Objectives, Organization, and Behavior
- L5 - Industrial Organization - - Regulation and Industrial Policy
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