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Relative and individual regulation: An investigation of investment incentives under a cost-plus approach

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  • Ebel, Nikos
  • Lefouili, Yassine

Abstract

We analyze the effects of a modified Yardstick competition on firms’ cost-reduction efforts. Departing from the existing literature, we use a relative cost-plus approach: firms are regulated on the basis of other firms’ performances, but they are granted a mark-up and not a lump-sum transfer in order to be compensated for their investments. We show that the cost-reduction effort of a regulated firm is decreasing in the mark-up under relative regulation while it is increasing in the mark-up under individual regulation. Hence, the trade-off between encouraging cost reduction and minimizing prices that the regulator faces under individual cost-plus regulation does not exist under relative cost-plus regulation. We extend our model by including technical spillovers and we investigate their effects on firms’ cost reduction efforts and on the efficiency of the whole industry. Finally, we allow for quality-enhancing investments and study the interplay between them and cost reduction investments under relative cost-plus regulation.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 7314.

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Date of creation: Feb 2008
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Handle: RePEc:pra:mprapa:7314

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Keywords: Yardstick Competition; Cost Reduction; Cost-Plus Regulation;

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