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Cost Padding in Regulated Markets with Demand Uncertainty

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  • Debora Di Gioacchino

Abstract

This 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 firms’ non-cooperative behaviour.

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Bibliographic Info

Paper provided by University of Rome La Sapienza, Department of Public Economics in its series Working Papers with number 72.

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Length: 32
Date of creation: May 2004
Date of revision:
Handle: RePEc:sap:wpaper:wp72

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Related research

Keywords: Strategic Behaviour; Cost Padding; Regulation; Demand Uncertainty.;

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References

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  1. Vives, Xavier, 1986. "Commitment, flexibility and market outcomes," International Journal of Industrial Organization, Elsevier, Elsevier, vol. 4(2), pages 217-229, June.
  2. Gabszewicz, J.J. & Poddar, S., . "Demand fluctuations and capacity utilization under duopoly," CORE Discussion Papers RP -1269, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  3. Bolle, Friedel, 2001. "Competition with supply and demand functions," Energy Economics, Elsevier, vol. 23(3), pages 253-277, May.
  4. Grossman, Sanford J, 1981. "Nash Equilibrium and the Industrial Organization of Markets with Large Fixed Costs," Econometrica, Econometric Society, Econometric Society, vol. 49(5), pages 1149-72, September.
  5. Bolle, Friedel, 1992. "Supply function equilibria and the danger of tacit collusion : The case of spot markets for electricity," Energy Economics, Elsevier, vol. 14(2), pages 94-102, April.
  6. Reynolds, Stanley S. & Wilson, Bart J., 2000. "Bertrand-Edgeworth Competition, Demand Uncertainty, and Asymmetric Outcomes," Journal of Economic Theory, Elsevier, vol. 92(1), pages 122-141, May.
  7. Albon, Robert P & Kirby, Michael G, 1983. "Cost-Padding in Profit-Regulated Firms," The Economic Record, The Economic Society of Australia, vol. 59(164), pages 16-27, March.
  8. Klemperer, Paul D & Meyer, Margaret A, 1989. "Supply Function Equilibria in Oligopoly under Uncertainty," Econometrica, Econometric Society, Econometric Society, vol. 57(6), pages 1243-77, November.
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