Firm Regulation and Profit-Sharing: A Real Option Approach

To avoid the extremely high profit levels found in recent experience of public utilities' regulation, some regulators have introduced a profit-sharing (PS) rule that revises prices to the benefit of consumers. However, in order to be successful, a PS rule should satisfy appropriate incentive conditions. In this paper, we study the incentive properties of a second best PS mechanism designed by the regulator to induce a regulated monopolist to divert its "excessive" profits to the customers. In a real option model where a regulated monopolist manages a long-term franchise contract and the regulator has the option to revoke the contract if there is serious welfare loss, we first endogenously derive the welfare maximising PS rule under the verifiability of profits. We then explore the dynamic efficiency of this PS rule under non-verifiability of profits and study the firm's incentive to comply with it in an infinite-horizon game. Finally, we derive the price adjustment path which follows the adoption of a PS rule in a price cap regulation. We show that the riskiness of the distribution of the firm's future profits and the regulator's cost in revoking the franchise contract are key factors in determining the equilibrium properties of a dynamic PS rule.