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The Quest for Quality: A Quality Adjusted Dynamic Regulatory Mechanism

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  • Gianni De Fraja
  • Alberto Iozzi

Abstract

"In situations where quality is fixed, the widely used RPI-X regulatory mechanism has a number of desirable properties, such as convergence to a second best optimum. Theoretical analysis of this mechanism in the case of endogenous quality is limited and therefore regulators have typically imposed constraints on the firm's quality choice in "ad hoc" manners, either by mandating quality levels, or by including quality adjustment factors in the RPI-X mechanism. In this paper, we construct the rigorous theoretical counterpart of these manners of including quality measures in the constraints faced by a regulated firm. This mechanism converges to second best optimum. It works by offering the firm trade-offs between prices and qualities based on the choice it made in the previous period; however, reflecting the practical problem valuing quality, the informational requirement to select these trade-offs appropriately is qualitatively stronger than in the fixed quality case. Moreover, even when the informational problem can be overcome, we identify a further potential pitfall in the approach taken in practice by regulators, and show that, in order to avoid it, the regulated firm should be subject to an additional constraint, which we label the distance constraint, and which can be interpreted as requiring the firms to choose prices and qualities within a band in every period." Copyright (c) 2008, The Author(s) Journal Compilation (c) 2008 Wiley Periodicals, Inc..

Suggested Citation

  • Gianni De Fraja & Alberto Iozzi, 2008. "The Quest for Quality: A Quality Adjusted Dynamic Regulatory Mechanism," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 17(4), pages 1011-1040, December.
  • Handle: RePEc:bla:jemstr:v:17:y:2008:i:4:p:1011-1040
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    Cited by:

    1. Stéphane Auray & Thomas Mariotti & Fabien Moizeau, 2011. "Dynamic regulation of quality," RAND Journal of Economics, RAND Corporation, vol. 42(2), pages 246-265, June.
    2. Gianni De Fraja & Emanuela Michetti & Piercarlo Zanchettin, 2011. "Toc 'n' Roll: Bargaining, Service Quality and Specificity in the UK Railway Network," Journal of Transport Economics and Policy, University of Bath, vol. 45(3), pages 383-414, September.
    3. Carlo Cambini & Elena Fumagalli & Laura Rondi, 2016. "Incentives to quality and investment: evidence from electricity distribution in Italy," Journal of Regulatory Economics, Springer, vol. 49(1), pages 1-32, February.
    4. Luigi Benfratello & Alberto Iozzi & Paola Valbonesi, 2009. "Technology and incentive regulation in the Italian motorways industry," Journal of Regulatory Economics, Springer, vol. 35(2), pages 201-221, April.
    5. Angela S. Bergantino & Etienne Billette de Villemeur & Annalisa Vinella, 2006. "A Model of Partial Regulation in the Maritime Ferry Industry," SERIES 0010, Dipartimento di Economia e Finanza - Università degli Studi di Bari "Aldo Moro", revised Jan 2006.
    6. David Sappington & Dennis Weisman, 2010. "Price cap regulation: what have we learned from 25 years of experience in the telecommunications industry?," Journal of Regulatory Economics, Springer, vol. 38(3), pages 227-257, December.
    7. Gui, Benedetto & de Villemeur, Étienne, 2007. "Regulation of a Monopoly Generating Externalities," IDEI Working Papers 469, Institut d'Économie Industrielle (IDEI), Toulouse, revised Jan 2011.
    8. Kevin Currier, 2006. "Quality-Adjusted Laspeyres Price Caps: A Graphical Analysis," Atlantic Economic Journal, Springer;International Atlantic Economic Society, vol. 34(4), pages 481-490, December.
    9. Armstrong, Mark & Sappington, David E.M., 2007. "Recent Developments in the Theory of Regulation," Handbook of Industrial Organization, Elsevier.
    10. Cesi Berardino & Iozzi Alberto & Valentini Edilio, 2012. "Regulating Unverifiable Quality by Fixed-Price Contracts," The B.E. Journal of Economic Analysis & Policy, De Gruyter, vol. 12(1), pages 1-39, September.
    11. Stéphane Auray & Thomas Mariotti & Fabien Moizeau, 2006. "Dynamic Regulation of Public Good Quality," Cahiers de recherche 0610, CIRPEE.
    12. David Sappington, 2005. "Regulating Service Quality: A Survey," Journal of Regulatory Economics, Springer, vol. 27(2), pages 123-154, November.
    13. Saha, Souresh, 2014. "Firm's objective function and product and process R&D," Economic Modelling, Elsevier, vol. 36(C), pages 484-494.

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