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Cost Padding in Regulated Markets with Demand Uncertainty

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  • Debora Di Gioacchino

Abstract

This paper presents a simple model of a non-competitive market with demand uncertainty in which firms can choose their technology of production. Technology is characterised by two parameters: capacity and flexibility. The first has a strong commitment value while flexibility is needed to face uncertainty. Lack of competition requires active regulation to ensure that the price is not set at excessive level. When choosing their technology, firms take into account not only the effects of this choice on the opponent(s) but also the effect on the regulated price. In this framework, and because of regulation, firms have an incentive to manipulate their costs (cost padding). This causes monopoly regulation aiming at improving allocative efficiency to be ineffective. Increasing the number of firms in the market may restore regulation effectiveness. The reason is that if demand is sufficiently volatile, then firms strategically choose flexible techniques and this effect dominates over the incentive to manipulate costs in order to escape regulation. In this case regulation is effective precisely because cost padding is hampered by firms’ non-cooperative behaviour.

Suggested Citation

  • Debora Di Gioacchino, 2004. "Cost Padding in Regulated Markets with Demand Uncertainty," Working Papers in Public Economics 72, Department of Economics and Law, Sapienza University of Roma.
    • Handle: RePEc:sap:wpaper:wp72
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    References listed on IDEAS

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    More about this item

    Keywords

    Strategic Behaviour; Cost Padding; Regulation; Demand Uncertainty.;
    All these keywords.

    JEL classification:

    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation
    • L10 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - General
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory

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