Cost Padding in Regulated Markets with Demand Uncertainty
AbstractThis paper presents a simple model of a non-competitive market with demand uncertainty in which firms can choose their technology of production. Technology is characterised by two parameters: capacity and flexibility. The first has a strong commitment value while flexibility is needed to face uncertainty. Lack of competition requires active regulation to ensure that the price is not set at excessive level. When choosing their technology, firms take into account not only the effects of this choice on the opponent(s) but also the effect on the regulated price. In this framework, and because of regulation, firms have an incentive to manipulate their costs (cost padding). This causes monopoly regulation aiming at improving allocative efficiency to be ineffective. Increasing the number of firms in the market may restore regulation effectiveness. The reason is that if demand is sufficiently volatile, then firms strategically choose flexible techniques and this effect dominates over the incentive to manipulate costs in order to escape regulation. In this case regulation is effective precisely because cost padding is hampered by firmsâ€™ non-cooperative behaviour.
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Bibliographic InfoPaper provided by University of Rome La Sapienza, Department of Public Economics in its series Working Papers with number 72.
Date of creation: May 2004
Date of revision:
Strategic Behaviour; Cost Padding; Regulation; Demand Uncertainty.;
Find related papers by JEL classification:
- L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation
- L10 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - General
- D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
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