History-dependent Quantity Regulation

Abstract

We consider an industry that becomes quantity regulated if production is too large. The threshold level of production at which regulation is implemented is unknown to the firms in the industry, and future rights to produce in the regulated situation are made dependent on current production. Hence, a firm produces in order to earn profit in the current period, and to secure property rights in the future; this latter motive is a form of rent-seeking behavior, and will tend to raise current production even though the aim of regulation may be to reduce it. The beneficial effects of an increase in current production must be weighed against the raised probability that regulation will be implemented in order to determine equilibrium production. We characterize this equilibrium, and look at the comparative static effects of changing various policy variables. We consider how a regulator can achieve a current production target and at the same time pursue his own private goals. For example, a regulator who cares about his image or probability of re-election may not wish to pursue a strict regulation policy for the industry in question. We show that a production target can be achieved whilst following a seemingly relaxed regulation policy due to the history dependence of the allocation rule. This provides a new justification for the use of history-dependent allocations in quantity regulation; these are widespread in practice, even though they may lead to various undesirable phenomena.