An Econometric Analysis of the Asymmetric Information, Regulator-Utility Interaction

Abstract

This paper presents procedures for estimating the parameters of a regulated firm's production function which explicitly model the impact of the private information possessed by utility in the regulatory process. The paper derives the optimal regulatory outcome for two cases: (1) the utility's private information is observable by the regulator and (2) only the distribution of the private information is observable by the regulator. Given a parametric form for the utility's production function, these optimal regulatory outcomes yield structural econometric models which can be estimated to recover the parameters of the regulated firm's production function. These models are estimated for the Class A California water utility industry, and the parameter estimates obtained are compared to those obtained from applying conventional cost-function estimation procedures. This estimation procedure recovers the parameters of the utility's production function as well as an estimate of the distribution function of the utility's private information parameter. Using a non-nested hypothesis testing procedure we find that the second private information model provides a superior description of the observed level of costs and output. The estimates from these models are then used to compute the increased production costs and output reduction which result from the utility's superior private information about its production process. We find noticeable, but not overwhelming, percentage cost increases introduced by this private information in the regulatory process. The major effect is the welfare loss to consumers from the reduction in output produced under asymmetric information versus symmetric information.