Information, auditing, and incentives in regulation.

Abstract

This dissertation uses laboratory economic experiments to test the incentive effects of regulatory policies and practices under asymmetric information conditions. Significant results and policy implications are obtained on the traditional use of rate-of-return regulation (RORR) to regulate natural monopolies, and on the practice of restricting such firms from entering ancillary markets. The objective of the first several chapters is to test the incentive effects of RORR on market performance. Results confirm long-standing theories of incentive malfunctions of RORR. One result shows that under voluntary compliance, RORR is completely ineffective for regulating single sellers when cost information is private to firms, allowing them to misrepresent costs and earn monopoly profits. When firm's do not know market demand, they capture less surplus, but still earn above RORR expected returns. When stochastic auditing is added varying penalty rates and audit probabilities, significant cost overestimates remain common. Theoretical analysis explains the potential source of this anomaly as being the use of historical cost information in rate setting when excess profits are used as the audit benchmark. Other results show that in perfect repeated static implementations of RORR, wasteful input use will occur manifested as rate base padding or Averch-Johnson type selection of inefficient input combinations. Another chapter addresses the consequences of deregulating RORR franchise firms allowing them to enter ancillary markets. A stylized model of the telecommunications industry is created and experimentally tested to determine if anti-competitive firm behavior results when entry restrictions are lifted. Results offer no support for the arguments that regulated firms will use monopoly market earnings to underwrite ancillary market operations ("deep pocket"), engage in predatory pricing, or unfair competition. Economic arguments for removing entry barriers to improve market performance (increased output and lower prices) are substantiated.