Third Approach: Incentive Regulation

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The third approach to dealing with information asymmetries and limiting the effects of market power is for the regulator to design and implement incentive schemes that reward the operator for using its private information to achieve the government’s objectives1. To be most effective, the reward should (1) provide the operator with additional units of something it wants – for example, profits – when the operator gives the government something it wants – for example, lower prices; (2) give the operator performance options that provide higher rewards for accepting more challenging performance goals; and (3) allow the operator to keep only a minimal reward – for example, accounting profits that are no greater than the operator’s cost of capital – when the operator chooses the least challenging performance goal. Cost of capital is the financial return that the operator must give to its investors and creditors to induce them to provide capital for the firm.2

Footnotes

  1. Price Level Regulation provides the primary information on incentive regulation, although Quality, Social, and Environmental Issues also examines incentives.
  2. Determination of Cost of Capital in Financial Analysis notes how to estimate the cost of equity and the cost of capital.