DP3200 Price Regulation, Investment and the Commitment Problem

Author(s): Paul L Levine, Neil Rickman
Publication Date: February 2002
Keyword(s): commitment, price regulation, under investment
JEL(s): L51
Programme Areas: Public Economics, Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=3200

We consider a dynamic model of price regulation with asymmetric information where strategic delegation is available to the regulator. Firms can sink non- contractible, cost-reducing investment but regulators cannot commit to future price levels. We fully characterize the Perfect Bayesian equilibria and show that, with incentive contracts but without delegation, under- and over-investment can occur. We then show that delegation to a suitable regulator can both improve investment incentives and ameliorate the ratchet effect by credibly offering the firm future rent. Simulations indicate significant welfare gains from these two effects and that a wide range of regulatory preferences can achieve this result.