Abstract
In the literature on price regulation, the price-cap mechanism is seen as a very powerful incentive mechanism towards efficiency improvements. What about quality investments? The empirical literature is not univocal: Some studies suggest a deterioration of quality, while others do not find any statistically significant impact. We analyze the incentive provided by price-cap regulation in a setting in which the investment decisions of the regulated firm suffer from hold-up, and contacts are incomplete. We show that the incentives to invest in cost-saving innovations can be fostered by a price-cap contract with a “sufficient” regulatory lag, while for other types of investments, such as quality enhancement, the same contract does not help. Furthermore, we show that if the firm faces a binding resource constraint the price-cap contract generates a crowding-out effect between the two types of investment. This might explain the non univocal empirical evidence.
Highlights
In the economic literature and in the practice of regulation, one of the most interesting mechanism is the pricecap
We show that the incentives to invest in cost-saving innovations can be fostered by a price-cap contract with a “sufficient” regulatory lag, while for other types of investments, such as quality enhancement, the same contract does not help
The empirical evidence from industries regulated by price-cap is not univocal: Some studies suggest a deterioration of investments on maintenance and quality enhancement [2,3], while others do not find any significant evidence of quality deterioration [4,5]
Summary
In the economic literature and in the practice of regulation, one of the most interesting mechanism is the pricecap. In the present work we focus on the second issue: the regulator’s commitment problem From this point of view, the price-cap mechanism may induce the first best level of investments by making the firm residual claimant of any efficiency improvement. This feature of the price-cap mechanism can be best understood in an incomplete contract environment, where the effects of investments are not verifiable in front of a court of law, ruling out contracts contingent on such investments [6, for an introduction to the incomplete contract approach]2. This implies that the firm and the regulator would bargain over the returns of the investments, and the length of the regulatory contract would play a crucial role in shaping the parties’ outside option
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
