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Risk, price regulation, and irreversible investment

  • Evans, Lewis T.
  • Guthrie, Graeme A.

We show that regulators' price-setting rate base and allowed rate of return decisions are inextricably linked. Once regulators switch from traditional rate of return regulation the irreversibility of much infrastructure investment significantly alters the results of the usual approach to price-setting as exemplified by Marshall Yawitz and Greenberg (1981). In particular the practice of 'optimizing' inefficient assets out of the regulated firm's rate base as in total element long-run incremental cost (TELRIC) calculations in telecommunications exposes the firm to demand risk. The firm requires an economically-significant premium for bearing this risk and this premium is an increasing function of the unsystematic risk of demand shocks. In addition we argue that if the firm is to break even under incentive regulation then the level of the rate base will not generally equal the optimized replacement cost.

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Article provided by Elsevier in its journal International Journal of Industrial Organization.

Volume (Year): 23 (2005)
Issue (Month): 1-2 (February)
Pages: 109-128

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Handle: RePEc:eee:indorg:v:23:y:2005:i:1-2:p:109-128
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505551

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  1. Daniel F. Spulber, 1989. "Regulation and Markets," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262192756, June.
  2. Jean-Jacques Laffont & Jean Tirole, 1993. "A Theory of Incentives in Procurement and Regulation," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262121743, June.
  3. Valerie A. Ramey & Matthew D. Shapiro, 2001. "Displaced Capital: A Study of Aerospace Plant Closings," Journal of Political Economy, University of Chicago Press, vol. 109(5), pages 958-992, October.
  4. Asplund, Marcus, 1995. "What Fraction of a Capital Investment is Sunk Cost?," SSE/EFI Working Paper Series in Economics and Finance 68, Stockholm School of Economics, revised 24 Sep 1999.
  5. Nicholas Economides, 1999. "Real Options and the Costs of the Local Telecommunications Network," Working Papers 99-11, New York University, Leonard N. Stern School of Business, Department of Economics.
  6. Jerry A. Hausman, 1997. "Valuing the Effect of Regulation on New Services in Telecommunications," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 28(1997 Micr), pages 1-54.
  7. Cowan, Simon, 2004. "Optimal risk allocation for regulated monopolies and consumers," Journal of Public Economics, Elsevier, vol. 88(1-2), pages 285-303, January.
  8. Hausman, Jerry & Myers, Stewart, 2002. "Regulating the United States Railroads: The Effects of Sunk Costs and Asymmetric Risk," Journal of Regulatory Economics, Springer, vol. 22(3), pages 287-310, November.
  9. Littlechild Stephen, 2003. "Reflections on Incentive Regulation," Review of Network Economics, De Gruyter, vol. 2(4), pages 1-27, December.
  10. Fisher, Franklin M & McGowan, John J, 1983. "On the Misuse of Accounting Rates of Return to Infer Monopoly Profits," American Economic Review, American Economic Association, vol. 73(1), pages 82-97, March.
  11. Mandy David M. & Sharkey William W., 2003. "Dynamic Pricing and Investment from Static Proxy Models," Review of Network Economics, De Gruyter, vol. 2(4), pages 1-37, December.
  12. Marshall, William J & Yawitz, Jess B & Greenberg, Edward, 1981. "Optimal Regulation under Uncertainty," Journal of Finance, American Finance Association, vol. 36(4), pages 909-21, September.
  13. D. J. Johnstone, 2003. "Replacement Cost Asset Valuation and Regulation of Energy Infrastructure Tariffs," Abacus, Accounting Foundation, University of Sydney, vol. 39(1), pages 1-41.
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