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Firm Regulation and Profit Sharing: A Real Option Approach

Author

Listed:
  • Moretto Michele

    (University of Padova)

  • Valbonesi Paola

    (University of Padova)

Abstract

To avoid the extremely high profit levels found in the recent experience of public utilities' regulation, some regulators have introduced a profit-sharing (PS) rule that revises prices to the benefit of consumers. However, in order to be successful, a PS rule should satisfy appropriate incentive conditions.In this paper, we study the incentive properties of a second best PS mechanism designed by the regulator to induce a regulated monopolist to divert its "excessive" profits to the customers. In a real option model where a regulated monopolist manages a long-term franchise contract and the regulator has the option to revoke the contract if there is serious welfare loss, we first endogenously derive the welfare maximising PS rule under the verifiability of profits. We then explore the dynamic efficiency of this PS rule under the non-verifiability of profits and study the firm's incentive to comply with it in an infinite-horizon game. Finally, we derive the price adjustment path which follows the adoption of a PS rule in a price cap regulation.We show that the riskiness of the distribution of the firm's future profits and the regulator's cost in revoking the franchise contract are key factors in determining the equilibrium properties of a dynamic PS rule.

Suggested Citation

  • Moretto Michele & Valbonesi Paola, 2007. "Firm Regulation and Profit Sharing: A Real Option Approach," The B.E. Journal of Economic Analysis & Policy, De Gruyter, vol. 7(1), pages 1-34, November.
    • Handle: RePEc:bpj:bejeap:v:7:y:2007:i:1:n:56
    DOI: 10.2202/1935-1682.1714
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    Cited by:

    1. D'Alpaos, Chiara & Moretto, Michele & Valbonesi, Paola & Vergalli, Sergio, 2009. ""It Is Never too late": Optimal Penalty for Investment Delay in Public Procurement Contracts," Institutions and Markets Papers 54351, Fondazione Eni Enrico Mattei (FEEM).
    2. Chiara D'Alpaos & Michele Moretto & Paola Valbonesi, 2008. "Optimal penalty for investment delay in public procurement contracts," "Marco Fanno" Working Papers 0074, Dipartimento di Scienze Economiche "Marco Fanno".

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    Keywords

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    JEL classification:

    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • L33 - Industrial Organization - - Nonprofit Organizations and Public Enterprise - - - Comparison of Public and Private Enterprise and Nonprofit Institutions; Privatization; Contracting Out
    • L5 - Industrial Organization - - Regulation and Industrial Policy

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