The choice of technology and capital structure under rate regulation

Abstract

This paper examines a regulated firm's choice of technology. It presents a model in which regulatory opportunism induces the firm to adopt a technology that gives rise to cost functions with higher variable costs and lower fixed costs than is socially optimal. This distortion arises because the regulated price is positively correlated with marginal costs. Consequently, a technology with low marginal costs implies a low regulated price and hence is unattractive to the firm. Debt financing is shown to alleviate this distortion because it induces regulators to increase the regulated price to prevent the firm from financial distress, thereby reducing the cost to the firm of adopting technologies with low marginal costs. When regulators restrict the firm's ability to issue debt, the firm may have an incentive to goldplate (i.e. waste resources). This incentive disappears when the firm can use its most preferred mode of financing.