The Behavior of a Firm Subject to Stochastic Regulatory Review

Abstract

In recent years, the behavior of regulated public utilities has received increasing attention from economic theorists. The principal structure used in analyzing this behavior has been the Averch-Johnson model of the regulated firm. The current paper presents an alternative view of the regulated firm, one which attempts to narrow some (though by no means all) of the gaps between the now standard model and the actual regulatory process. In particular, the new model proposed here considers the firm's operations in a dynamic context -- with the firm looking to the future in making today's decisions -- and it incorporates the interplay between the regulatory agency and the firm. The model captures the price-setting role of the regulators, and it encompasses the phenomenon of regulatory lag. The uncertainty associated with the occurrence of rate reviews is modeled by positing that reviews occur stochastically through time. And, although the treatment of the issue is rather simplistic, the model does incorporate technical change generated by the regulated firm's program of research and development. The regulated firm's optimal policy is characterized, and the implications this optimal policy has for two traditional issues in regulatory economics -- the input efficiency of regulated firms and the effect of regulatory lag on research and development -- are examined.