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2003Michele Moretto and Paola Valbonesi
Opting-out in profit-sharing regulation
ABSTRACT
To avoid the extremely high profit levels found in recent experiences
with price cap regulation, some regulators have proposed a
profit-sharing mechanism that revises prices to the benefit of consumers.
This paper investigates the conditions under which a regulator
can implement such a profit-sharing scheme, having the option to
revoke the contract if the firm’s profits are excessive.
When this option is included in the regulator’s objective function
and the cost of exercising it is not too high, a long-term equilibrium
arises with a state-contingent sharing rule that guarantees an appropriate
level of profits. The model determines both the level of profits
that triggers the profit-sharing mechanism and the consequent price
adjustment endogenously. There is an endogenous regulatory lag initially
characterized by a price cap regulation, followed by a period
of profit-sharing regime where the firm is motivated to cut prices to
avoid revocation.
