Diversification Incentives under "Price-Based" and "Cost-Based" Regulation

Abstract

This article considers two schemes of regulationforfirms that serve both monopoly markets and markets subjected to substantial competition. The first form (cost-based regulation) combines elements of rate-of-return regulation (on monopoly markets) with filly distributed cost pricing, much like the form of regulation currently in place in the domestic telephone industry. The secondform (price-based regulation) would establish rate caps on noncompetitive services, and allow the firm to enter into competitive markets and charge whatever prices it might like in those markets. Models of both forms of regulation are developed and analyzed with respect to incentives for cost misreporting, choice of technology, cost-reducing innovation, choices of prices and output levels, and diversification into competitive markets.