DP4502 Bigger and Better: A Dynamic Regulatory Mechanism for Optimum Quality

Author(s): Gianni De Fraja, Alberto Iozzi
Publication Date: August 2004
Keyword(s): price cap, quality, regulation, RPI-X
JEL(s):
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=4502

Vogelsang and Finsinger’s seminal paper (Bell Journal of Economics, 1979) proposes a mechanism for price regulation with some desirable properties, such as convergence to a second best optimum. This mechanism applies to situations where quality is fixed: in practice, quality can be varied by the firm, and regulators have typically imposed constraints on the firm’s quality choice. This Paper lays a rigorous theoretical foundation to the inclusion of quality measures in the constraints faced by a regulated firm. We identify a potential pitfall in the approach taken in practice by regulators, and show that, in order to avoid it, the regulated firm should be subject to an additional constraint, which, loosely speaking, requires firms’ choices not to be too erratic.