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Regulatory Risk under Optimal Incentive Regulation

  • Roland Strausz

The paper provides a tractable, analytical framework to study regulatory risk under optimal incentive regulation. Regulatory risk is captured by uncertainty about the policy variables in the regulator’s objective function: weights attached to profits and costs of public funds. Results are as follows: 1) The regulator’s reaction to regulatory risk depends on the curvature of the aggregate demand function. 2) It yields a positive information rent effect exactly when demand is convex. 3) Firms benefit from regulatory risk exactly when demand is convex. 4) Consumers’ risk preferences tend to contradict the firm’s. 5) Benevolent regulators always prefer regulatory risk and these preferences may contradict both the firm’s and consumers’ preferences.

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File URL: http://sfb649.wiwi.hu-berlin.de/papers/pdf/SFB649DP2009-006.pdf
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Paper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number SFB649DP2009-006.

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Length: 32 pages
Date of creation: Jan 2009
Date of revision:
Handle: RePEc:hum:wpaper:sfb649dp2009-006
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  1. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
  2. Jean-Jacques Laffont & Jean Tirole, 1985. "The Dynamics of Incentive Contracts," Working papers 397, Massachusetts Institute of Technology (MIT), Department of Economics.
  3. Samuelson, Paul A, 1972. "The Consumer Does Benefit From Feasible Price Stability," The Quarterly Journal of Economics, MIT Press, vol. 86(3), pages 476-93, August.
  4. Laffont, Jean-Jacques & Tirole, Jean., 1988. "Adverse Selection and Renegotiation in Procurement," Working Papers 665, California Institute of Technology, Division of the Humanities and Social Sciences.
  5. Miles S. Kimball, 1989. "Precautionary Saving in the Small and in the Large," NBER Working Papers 2848, National Bureau of Economic Research, Inc.
  6. Pindyck, Robert S., 1986. "Irreversible investment, capacity choice, and the value of the firm," Working papers 1802-86., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  7. Armstrong, Mark & Sappington, David E.M., 2007. "Recent Developments in the Theory of Regulation," Handbook of Industrial Organization, Elsevier.
  8. Auriol, Emmanuelle & Warlters, Michael, 2006. "The Marginal Cost of Public Funds in Developing Countries: An Application to 38 African Countries," CEPR Discussion Papers 6007, C.E.P.R. Discussion Papers.
  9. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, vol. 73(1), pages 228-33, March.
  10. Laffont, Jean-Jacques & Tirole, Jean, 1986. "Using Cost Observation to Regulate Firms," Journal of Political Economy, University of Chicago Press, vol. 94(3), pages 614-41, June.
  11. 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.
  12. Roland Strausz, . "Deterministic versus Stochastic Mechanisms in Principal--Agent Models," Papers 020, Departmental Working Papers.
  13. Kolbe, A Lawrence & Tye, William B, 1996. "Compensation for the risk of stranded costs," Energy Policy, Elsevier, vol. 24(12), pages 1025-1050, December.
  14. David J. Salant & Glenn A. Woroch, 1992. "Trigger Price Regulation," RAND Journal of Economics, The RAND Corporation, vol. 23(1), pages 29-51, Spring.
  15. Paolo M. Panteghini & Carlo Scarpa, 2003. "Irreversible Investments and Regulatory Risk," CESifo Working Paper Series 934, CESifo Group Munich.
  16. Chang, Mo Ahn & Thompson, Howard E, 1989. "An Analysis of Some Aspects of Regulatory Risk and the Required Rate of Return for Public Utilities," Journal of Regulatory Economics, Springer, vol. 1(3), pages 241-57, September.
  17. Thomas P. Lyon & John W. Mayo, 2005. "Regulatory Opportunism and Investment Behavior: Evidence from the U.S. Electric Utility Industry," RAND Journal of Economics, The RAND Corporation, vol. 36(3), pages 628-644, Autumn.
  18. Hartman, Richard, 1972. "The effects of price and cost uncertainty on investment," Journal of Economic Theory, Elsevier, vol. 5(2), pages 258-266, October.
  19. Richard J. Gilbert & David M. Newbery, 1994. "The Dynamic Efficiency of Regulatory Constitutions," RAND Journal of Economics, The RAND Corporation, vol. 25(4), pages 538-554, Winter.
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