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Dynamically-Efficient Incentive Regulation of Networks with Sunk Costs

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  • Evans, Lewis
  • Guthrie, Graeme

Abstract

Incentive regulation allows decentralised decision-making under regulatory parameters set on the basis of industry characteristics. When there is uncertainty, sunk costs, and flexibility in the timing of investment a monopoly will invest later than is socially desirable because it garners only a fraction of the benefits, This study considers the design of regulatory profit caps based on a measure of costs, either historical or replacement costs, to which a regulatory rate of return is applied. It demonstrates that the sources and extent of supply and demand uncertainities, and thereby characteristics of the industry, determine whether historical or replacement cost regulation is desirable. The welfare optimising level of the regulatory rate of return differs between historical and replacement cost regulation, this return is generally higher than the weighted average cost of capital, and welfare is degraded much more if it is set below, as opposed to above, the optimal regulatory return.

Suggested Citation

  • Evans, Lewis & Guthrie, Graeme, 2002. "Dynamically-Efficient Incentive Regulation of Networks with Sunk Costs," Working Paper Series 33509, Victoria University of Wellington, School of Economics and Finance.
  • Handle: RePEc:vuw:vuwecf:33509
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    File URL: https://ir.wgtn.ac.nz/handle/123456789/33509
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    References listed on IDEAS

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    1. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474, December.
    2. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-186, March.
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