Abstract
This article addresses the problem faced by a regulated natural monopolist who must raise outside funds to finance socially desirable projects. We demonstrate that “fair rate of return” utility price regulation will lead to underinvestment incentives in the presence of asymmetric information between the firm and the capital markets regarding the firm's assets and future costs. This problem is especially severe when financing choice is restricted to equity. Underinvestment can be either completely eliminated by adjusting the allowed rate of return above the fair rate or reduced by switching to debt finance.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
References
Averch, H., and L. L. Johnson. 1962. “Behavior of the Firm under Regulatory Constraint.”American Economic Review 52: 1052–1069.
Banks, J. S., and J. Sobel. 1987. “Equilibrium Selection in Signalling Games.”Econometrica 55: 647–661.
Baron, D. P., and D. Besanko. 1987. “Commitment and Fairness in a Dynamic Regulatory Relation-ship.”Review of Economic Studies 54: 413–436.
Baumol, W. J. 1968. “Reasonable Rules for Rate Regulation.” InIssues in Theory, Practice and Public Policy, edited by A. Phillips: Philadelphia, PA: University of Pennsylvania Press.
Berg, S.V., and J. Tschirhart. 1988.Natural Monopoly Regulation.Cambridge, MA: Cambridge University Press.
Cho, I., and D. M. Kreps. 1987. “Signalling Games and Stable Equilibria.”Quarterly Journal of Economics 102: 179–222.
Greenwald, B. C. 1984. “Rate Base Selection and the Structure of Regulation.”RAND Journal of Economics 15: 85–95.
Hotelling, H. 1938. “The General Welfare in Relation to Problems of Taxation and Railway and Utility Rates.”Econometrica 6: 242–269.
Joskow, P. L. 1972. “The Determinants of the Allowed Rate of Return in a Formal Regulatory Hearing.”Bell Journal of Economics 3: 632–644.
Joskow, P. L. 1974. “Inflation and Environmental Concerns: Structural Change in the Process of Public Utility Price Regulation.”Journal of Law and Economics 17: 291–327.
Lewis, T. R., and D. E. M. Sappington. 1989. “Regulatory Options and Price-Cap Regulation.”RAND Journal of Economics 20: 405–416.
McConnell, M. W. 1988. “Public Utilities’ Private Rights: Paying for Failed Nuclear Power Projects.”Regulation (No. 2): 35–43.
Myers, S. M. 1977 ”Determinants of Corporate Borrowing.”Journal of Financial Economics 5: 147–175.
Myers, S. M., and N. Majluf. 1984. “Corporate Financing and Investment Decisions when Firms have Information Investors do not have.”Journal of Financial Economics 13:197–221.
Osbon, A. D. 1983. “The Market Environment for Utility Securities.” InCurrent Issues in PublicUtility Economics: Essays in Honor of James C. Bonbright; edited by A.L. Danielsen and D.R. Kamerschen. Toronto: Lexington Books.
Sibley, D. 1989. “Asymmetric Information, Incentives and Price-Cap Regulation.”RAND Journal of Economics 20: 392–404.
Author information
Authors and Affiliations
Additional information
Support from the Center for the Study of Regulated Industry at Georgia State University is gratefully acknowledged. We have benefited from the comments of Victor Andrews, two anonymous reviewers, and the editor, Michael A. Crew. The usual disclaimer applies.
Rights and permissions
About this article
Cite this article
Kale, J.R., Noe, T.H. Dilution costs, underinvestment, and utility regulation under asymmetric information. J Regul Econ 7, 177–197 (1995). https://doi.org/10.1007/BF01062690
Issue Date:
DOI: https://doi.org/10.1007/BF01062690