NDLI: Incentive Regulation of Prices When Costs are Sunk

Content Provider	Springer Nature Link
Author	Evans, Lewis Guthrie, Graeme
Copyright Year	2006
Abstract	We present a model featuring irreversible investment, economies of scale, uncertain future demand and capital prices, and a regulator who sets the firm’s output price according to the cost structure of a hypothetical replacement firm. We show that a replacement firm has a fundamental cost advantage over the regulated firm: it can better exploit the economies of scale because it has not had to confront the historical uncertainties faced by the regulated firm. We show that setting prices so low that a replacement firm is just willing to participate is insufficient to allow the regulated firm to expect to break even whenever it has to invest. Thus, unless the regulator is willing to incur costly monitoring to ensure the firm invests, revenue must be allowed in excess of that required for a replacement firm to participate. This contrasts with much of the existing literature, which argues that the market value of a regulated firm should equal the cost of replacing its existing assets. We also obtain a closed-form solution for the regulated firm’s output price when this price is set at discrete intervals. In contrast to rate of return regulation, we find that resetting the regulated price more frequently can increase the risk faced by the firm’s owners, and that this is reflected in a higher output price and a higher weighted-average cost of capital.
Starting Page	239
Ending Page	264
Page Count	26
File Format	PDF
ISSN	0922680X
Journal	Journal of Regulatory Economics
Volume Number	29
Issue Number	3
e-ISSN	15730468
Language	English
Publisher	Kluwer Academic Publishers
Publisher Date	2006-01-01
Publisher Place	Boston
Access Restriction	One Nation One Subscription (ONOS)
Subject Keyword	Incentive regulation Uncertainty Sunk costs Economies of scale Industrial Organization Microeconomics Public Finance & Economics
Content Type	Text
Resource Type	Article
Subject	Economics and Econometrics

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1	Ministry of Education (GoI), Department of Higher Education	Sanctioning Authority	https://www.education.gov.in/ict-initiatives
2	Indian Institute of Technology Kharagpur	Host Institute of the Project: The host institute of the project is responsible for providing infrastructure support and hosting the project	https://www.iitkgp.ac.in
3	National Digital Library of India Office, Indian Institute of Technology Kharagpur	The administrative and infrastructural headquarters of the project	Dr. B. Sutradhar bsutra@ndl.gov.in
4	Project PI / Joint PI	Principal Investigator and Joint Principal Investigators of the project	Dr. B. Sutradhar bsutra@ndl.gov.in Prof. Saswat Chakrabarti will be added soon
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