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Regulation with 20-20 Hindsight: "Heads I Win, Tails You Lose"?

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  • Thomas P. Lyon

Abstract

Regulators are commonly accused of using 20-20 hindsight to punish a firm for bad outcomes rather than bad decisions; it is often thought that such penalties lead to underinvestment by the firm. I find that this expectation is not borne out when retrospective review is based on the firm's avoided costs. In a Joskow-type model, hindsight review mitigates the firm's tendency to build oversized risky projects, moving the firm closer to the cost-minimizing level of investment. In a rate-of-return model, the firm's allowed rate of return may have to be increased to keep expected profits nonnegative. If this is done, hindsight review does not affect the firm's investment level, but it does correct the (risk-neutral) firm's tendency to pay an excessive premium to eliminate construction cost uncertainty.

Suggested Citation

  • Thomas P. Lyon, 1991. "Regulation with 20-20 Hindsight: "Heads I Win, Tails You Lose"?," RAND Journal of Economics, The RAND Corporation, vol. 22(4), pages 581-595, Winter.
  • Handle: RePEc:rje:randje:v:22:y:1991:i:winter:p:581-595
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    Cited by:

    1. Larry Blank & John Mayo, 2009. "Endogenous Regulatory Constraints and the Emergence of Hybrid Regulation," Review of Industrial Organization, Springer;The Industrial Organization Society, vol. 35(3), pages 233-255, November.
    2. Maxwell, John W & Lyon, Thomas P & Hackett, Steven C, 2000. "Self-Regulation and Social Welfare: The Political Economy of Corporate Environmentalism," Journal of Law and Economics, University of Chicago Press, vol. 43(2), pages 583-617, October.
    3. Roland Strausz, 2009. "Regulatory Risk under Optimal Incentive Regulation," CESifo Working Paper Series 2638, CESifo Group Munich.
    4. Stratford Douglas & Thomas A. Garrett & Russell M. Rhine, 2009. "Disallowances and overcapitalization in the U.S. electric utility industry," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 23-32.
    5. 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.
    6. Spiller, Pablo T. & Vogelsang, Ingo & DEC, 1994. "Regulation, institutions, and commitment in the British telecommunications sector," Policy Research Working Paper Series 1241, The World Bank.
    7. Kumkar, Lars, 2001. "Strommarkt Kalifornien: Ein Liberalisierungsmodell kämpft um das politische Überleben," Kiel Working Papers 1023, Kiel Institute for the World Economy (IfW).
    8. Kumkar, Lars, 2001. "Strommarktliberalisierung in Kalifornien: Schlägt das Pendel zurück?," Kiel Discussion Papers 378/379, Kiel Institute for the World Economy (IfW).
    9. Armstrong, Mark & Sappington, David E.M., 2007. "Recent Developments in the Theory of Regulation," Handbook of Industrial Organization, Elsevier.

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