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Incentive Regulation of Prices When Costs are Sunk

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  • Lewis Evans

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  • Graeme Guthrie

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Abstract

We present a model featuring irreversible investment, economies of scale, uncertain future demand and capital prices, and a regulator who sets the firm’s output price according to the cost structure of a hypothetical replacement firm. We show that a replacement firm has a fundamental cost advantage over the regulated firm: it can better exploit the economies of scale because it has not had to confront the historical uncertainties faced by the regulated firm. We show that setting prices so low that a replacement firm is just willing to participate is insufficient to allow the regulated firm to expect to break even whenever it has to invest. Thus, unless the regulator is willing to incur costly monitoring to ensure the firm invests, revenue must be allowed in excess of that required for a replacement firm to participate. This contrasts with much of the existing literature, which argues that the market value of a regulated firm should equal the cost of replacing its existing assets. We also obtain a closed-form solution for the regulated firm’s output price when this price is set at discrete intervals. In contrast to rate of return regulation, we find that resetting the regulated price more frequently can increase the risk faced by the firm’s owners, and that this is reflected in a higher output price and a higher weighted-average cost of capital. Copyright Springer Science+Business Media, Inc. 2006

Suggested Citation

  • Lewis Evans & Graeme Guthrie, 2006. "Incentive Regulation of Prices When Costs are Sunk," Journal of Regulatory Economics, Springer, vol. 29(3), pages 239-264, May.
  • Handle: RePEc:kap:regeco:v:29:y:2006:i:3:p:239-264 DOI: 10.1007/s11149-006-7398-0
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    References listed on IDEAS

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    Cited by:

    1. Evans, Lewis & lu, Yinjia (Andrea) & Guthrie, Graeme, 2010. "A New Zealand Electricity Market Model: Assessment of the effect of climate change on electricity production and consumption," Working Paper Series 4058, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    2. Diego Restrepo-Tobón & Subal Kumbhakar & Kai Sun, 2015. "Obelix vs. Asterix: Size of US commercial banks and its regulatory challenge," Journal of Regulatory Economics, Springer, vol. 48(2), pages 125-168, October.
    3. Dominik Schober, 2013. "Refinancing under Yardstick Regulation with Investment Cycles–The Case of Long-Lived Electricity Network Assets," EWL Working Papers 1321, University of Duisburg-Essen, Chair for Management Science and Energy Economics, revised Jun 2013.
    4. de Braganca, Gabriel Fiuza & Rocha, Katia & Moreira, Rafael Henrique Rodrigues, 2008. "Real Options and the Regulation of Brazilian Fixed-Line Telephone Operators: The Mark-up on the Cost of Capital," Working Paper Series 3997, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    5. Ingo Vogelsang, 2012. "Incentive Regulation, Investments and Technological Change," Chapters,in: Regulation and the Performance of Communication and Information Networks, chapter 4 Edward Elgar Publishing.
    6. Evans, Lewis, 2010. "Infrastructure Investment Under Uncertainty," Working Paper Series 4068, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    7. Hahn, Robert & Evans, Lewis, 2010. "Regulating Dynamic Markets: Progress in Theory and Practice," Working Paper Series 4052, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    8. Vogelsang Ingo, 2013. "The Endgame of Telecommunications Policy? A Survey," Review of Economics, De Gruyter, vol. 64(3), pages 193-270, December.
    9. J-M- Glachant & H. Khalfallah & Y. Perez & V. Rious & M. Saguan, 2013. "Implementing Incentive Regulation and Regulatory Alignment with Resource Bounded Regulators," Competition and Regulation in Network Industries, Intersentia, vol. 14(3), pages 265-291, September.
    10. Schober, Dominik & Weber, Christoph, 2015. "Refinancing under yardstick regulation with investment cycles: The case of long-lived electricity network assets," ZEW Discussion Papers 15-065, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
    11. Ian Dobbs, 2011. "Modeling welfare loss asymmetries arising from uncertainty in the regulatory cost of finance," Journal of Regulatory Economics, Springer, vol. 39(1), pages 1-28, February.
    12. Graeme Guthrie, 2006. "Regulating Infrastructure: The Impact on Risk and Investment," Journal of Economic Literature, American Economic Association, vol. 44(4), pages 925-972, December.
    13. Moutinho, Victor & Moreira, António C. & Mota, Jorge, 2014. "Do regulatory mechanisms promote competition and mitigate market power? Evidence from Spanish electricity market," Energy Policy, Elsevier, vol. 68(C), pages 403-412.
    14. Leme, Rafael C. & Paiva, Anderson P. & Steele Santos, Paulo E. & Balestrassi, Pedro P. & Galvão, Leandro de Lima, 2014. "Design of experiments applied to environmental variables analysis in electricity utilities efficiency: The Brazilian case," Energy Economics, Elsevier, vol. 45(C), pages 111-119.
    15. Franklin, Sergio Luis & Diallo, Madiagne, 2013. "Real options and cost-based access pricing: Model and methodology," Telecommunications Policy, Elsevier, vol. 37(4), pages 321-333.
    16. Jean-Michel Glachant & Haikel Khalfallah & Yannick Perez & Vincent Rious & Marcelo Saguan, 2013. "Implementing incentive regulation through an alignment with resource bounded regulators," Post-Print halshs-00767872, HAL.
    17. Boyle, Glenn & Evans, Lewis & Guthrie, Graeme, 2006. "Estimating the WACC in a Regulatory Setting: An Assessment of Dr Martin Lally's paper 'The Weighted Average Cost of Capital for Electricity Lines Businesses' of 8 September 2005," Working Paper Series 3844, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.

    More about this item

    Keywords

    Incentive regulation; Uncertainty; Sunk costs; Economies of scale; G31; L5;

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • L5 - Industrial Organization - - Regulation and Industrial Policy

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