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Cost Padding in Regulated Monopolies

Author

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  • Spiros Bougheas

    (Department of Economics, Nottingham University)

  • Tim Worrall

    () (Department of Economics, Keele University, Keele,)

Abstract

In this paper we consider a regulated monopoly that can pad its costs to increase its cost reimbursement. Even while padding is ineácient the optimal incentive scheme tolerates some padding of costs to reduce the information rents paid to low cost types. It is shown that high cost firms pad costs more than low cost ßrms. We also show that cost padding moves pricing away from Ramsay optimal pricing toward more monopolistic pricing rules. We show that when auditing of total costs is costly, low cost firms face a fixed price contract and engage in no cost padding. High cost ßrms do less well but do engage in padding to increase the verified cost. If padded costs can be audited at some cost, low cost types engage in cost padding but high cost types do not. We also endogenize the distribution of cost types by allowing firms to engage in a pre-contractual, non-observable or verißable cost-reducing investment. The firm adopts a mixed strategy and this determines the distribution of cost types at the contracting stage. An example is given to show how the equilibrium distribution is computed.

Suggested Citation

  • Spiros Bougheas & Tim Worrall, 2001. "Cost Padding in Regulated Monopolies," Keele Department of Economics Discussion Papers (1995-2001) 2001/07, Department of Economics, Keele University, revised Nov 2001.
  • Handle: RePEc:kee:keeldp:2001/07
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    References listed on IDEAS

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    Cited by:

    1. Olga Chiappinelli, 2016. "Political Corruption in the Execution of Public Contracts," Discussion Papers of DIW Berlin 1607, DIW Berlin, German Institute for Economic Research.
    2. Chiappinelli, Olga, 2016. "Political corruption in the execution of public contracts," MPRA Paper 73487, University Library of Munich, Germany.
    3. Garret Kent Fellows, "undated". "Capital Input Decisions under Rate of Return Regulation," Working Papers 2014-37, Department of Economics, University of Calgary, revised 06 Nov 2014.

    More about this item

    Keywords

    Regulation; cost padding; costly state falsißcation; costly state verification; endogenous screening.;

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • L2 - Industrial Organization - - Firm Objectives, Organization, and Behavior
    • L5 - Industrial Organization - - Regulation and Industrial Policy

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