Catherine De Fontenay and Sven Feldmann discuss Nobel prize-winner Jean Tirole’s work on how to regulate monopolies:
If the regulator imposes a rigid price cap, the firm has an incentive to operate efficiently and minimise costs; but since the regulator does not know the firm’s overall costs, the firm may either be very profitable or at the brink of bankruptcy depending on where the price cap was set. To avoid this problem regulators moved to regulating the rate-of-return the firm is allowed to earn based on what is deemed a “reasonable” rate of return on the firm’s investments.
But as a result the firm no longer has an incentive to operate efficiently—indeed, additional capital investments raise the cost-base on which the rate of return is calculated and thus increase the firm’s total profits. In the context of the Australian electricity grid this phenomenon is known as “gold-plating”. Thus each of these two forms of regulation addresses one problem while exacerbating the other….
This is a common problem in dealing with public utilities and even with departments within government. Absence of competition bedevils the process. Fixed price caps lead to poor quality service, while cost-plus pricing introduces an incentive to inflate expenses. The challenge is to balance the two incentives: negotiate low-margin, cost-plus pricing but with incentives for service quality and efficiency.
Read more at Nobel economics prize winner an economist and a gentleman.