Optimal regulation of technical progress in natural monopolies with asymmetric information

Thomas Kuhn () and Uwe Cantner
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Thomas Kuhn: University of Technology Chemnitz-Zwickau, D-09107 Chemnitz, Germany

Review of Economic Design, 1999, vol. 4, issue 3, 204 pages

Abstract: The focus of this paper is to characterize regulatory mechanisms for natural monopolies to provide for optimal technical progress when information is asymmetric. We model a Bayesian-Nash game where the monopolist has private knowledge of the cost-reducing effects of R&D investment to generate process innovations. In the first case, a price-regulated, profit-maximizing firm whose R&D level is unobservable sets its R&D level efficiently to maximize profits at the output level chosen by the firm. However, the level of technical progress achieved by the firm in this case is too high from the regulator's point of view since, in the second-best regulated solution of interest, the regulator has to provide for the R&D expenditures, assumed sunk, as well as for information rents transferred to the firm. In a second case, it can be shown that if the regulator can observe and set limits on the firm's investment in R&D, social welfare is improved, even though the regulated investment level is no longer efficient at the output level chosen by the firm. The reason for the welfare improvement is that losses in consumer surplus due to a decrease in output and an increase in the price are offset by a decrease in information rents and R&D costs transferred, causing the social costs of public funds to fall.

Keywords: Industrial regulation; technical progress; natural monopoly; institutions and incentives (search for similar items in EconPapers)
JEL-codes: H42 L51 O3 (search for similar items in EconPapers)
Date: 1999-09-24
Note: Received: 31 July 1994 / Accepted: 15 January 1999
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