Asymmetric Information, Incentives and Price-Cap Regulation

Abstract

A regulatory incentive mechanism is presented in which the regulated firm has superior information about both cost and demand, compared to the regulator. The mechanism leads to truthful revelation of the demand function and extracts all rents due to private demand information in a nondistorting way. The scheme assumes that the regulator can observe lagged expenditures by the firm. This mechanism leads to efficient pricing, operating, and investment behavior by the firm. Finally, it is shown that the mechanism is closely related to recent proposals for price-cap regulation and that under certain assumptions simple modifications of these proposals will lead to the mechanisms discussed herein.