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Cost Padding in Regulated Monopolies

  • Spiros Bougheas

    (Department of Economics, Nottingham University)

  • Tim Worrall

    ()

    (Department of Economics, Keele University, Keele,)

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.

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File URL: http://www.keele.ac.uk/depts/ec/wpapers/0107.pdf
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Paper provided by Department of Economics, Keele University in its series Keele Department of Economics Discussion Papers (1995-2001) with number 2001/07.

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Length: 33 pages
Date of creation: Mar 2001
Date of revision: Nov 2001
Publication status: Published in
Handle: RePEc:kee:keeldp:2001/07
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Department of Economics, University of Keele, Keele, Staffordshire, ST5 5BG - United Kingdom

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  1. Michael D. Grubb, 2009. "Selling to Overconfident Consumers," American Economic Review, American Economic Association, vol. 99(5), pages 1770-1807, December.
  2. Baron, David P & Myerson, Roger B, 1982. "Regulating a Monopolist with Unknown Costs," Econometrica, Econometric Society, vol. 50(4), pages 911-30, July.
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  8. Laffont, Jean-Jacques, 1992. "The New Economics of Regulation Ten Years After," IDEI Working Papers 22, Institut d'Économie Industrielle (IDEI), Toulouse.
  9. Rauf Gönenç & Maria Maher & Giuseppe Nicoletti, 2003. "The Implementation and the Effects of Regulatory Reform: Past Experience and Current Issues," OECD Economic Studies, OECD Publishing, vol. 2001(1), pages 11-98.
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  11. Jean Tirole & Jean-Jaques Laffont, 1985. "Using Cost Observation to Regulate Firms," Working papers 368, Massachusetts Institute of Technology (MIT), Department of Economics.
  12. Albon, Robert P & Kirby, Michael G, 1983. "Cost-Padding in Profit-Regulated Firms," The Economic Record, The Economic Society of Australia, vol. 59(164), pages 16-27, March.
  13. Giovanni Maggi & Andres Rodriguez-Clare, 1995. "Costly Distortion of Information in Agency Problems," RAND Journal of Economics, The RAND Corporation, vol. 26(4), pages 675-689, Winter.
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  15. Ilya Segal & Michael D. Whinston, 2002. "The Mirrlees Approach to Mechanism Design with Renegotiation (with Applications to Hold-up and Risk Sharing)," Econometrica, Econometric Society, vol. 70(1), pages 1-45, January.
  16. Lacker, J.M., 1989. "Optimal Contracts Under Costly State Falsification," Purdue University Economics Working Papers 956, Purdue University, Department of Economics.
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