DP4035 Dynamic Yardstick Regulation

Author(s): Antoine Faure-Grimaud, Sönje Kerrin Reiche
Publication Date: August 2003
Keyword(s): commitment, ratchet effect, short- and long-term contracts, yardstick regulation
JEL(s): D82
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=4035

This Paper shows that the inability of regulators to commit to long-term contracts is irrelevant when there is some competition between regulated firms and when firms’ private information is correlated. This sharply contrasts with the dynamic of regulation without such competition. The Paper also explores what limitations on yardstick mechanisms can justify the use of long-term contracts. We found that the inability of a regulator to commit to not renegotiating long-term contracts is without consequences even if there is a bound on transfers that a firm can be asked to pay. In contrast, short-term contracting fails to implement the commitment solution with constraints on transfers. Second, absent current competition, the possibility of future entry allows the regulator to implement the first-best with a renegotiation-proof long-term contract whereas this cannot be achieved with short-term contracting.