Relative And Individual Regulation: An Investigation Of Investment Incentives Under A Cost-Plus Approach

The authors analyze the effects of a modified Yardstick competition on firms' cost-reduction efforts. Departing from the existing literature, they use a relative cost-plus approach: firms are regulated on the basis of other firms' performances, but they are granted a mark-up and not a lump-sum transfer in order to be compensated for their investments. They show that the cost-reduction effort of a regulated firm is decreasing in the mark-up under relative regulation while it is increasing in the mark-up under individual regulation. Hence, the trade-off between encouraging cost reduction and minimizing prices that the regulator faces under individual cost-plus regulation does not exist under relative cost-plus regulation.