The power of regulatory regimes reexamined

Abstract

The literature finds that pure price cap regulation (PCR) is a high-powered regulatory regime because it elicits the first-best level of cost-reducing effort. Conversely, the regulated firm underinvests in cost-reducing effort under PCR with earnings sharing. These findings, while standard in the literature, do not consider the strategic behavior of the regulator ex post. When the regulator controls competitive entry and the Hope standard applies the regulated firm is no longer the residual claimant for its efficiency gains even under pure PCR. The findings of the literature are reversed in this setting. The power of the regulatory regime may be higher under PCR with earnings sharing than under pure PCR. In fact, over a wide range of welfare weights, equilibrium investment in cost-reducing effort is zero under pure PCR. This may explain why the empirical evidence on the efficiency gains from PCR falls short of an unequivocal validation of the theory.