REGULATION AS A BARGAINING PROCESS - NEGOTIATION OVER PRICE AND COST-REDUCING INVESTMENTS

This paper develops the idea that industry regulation can be treated as a bargaining between a firm and the public authority, and illustrates some consequences of this formulation. We investigate a typical regulatory problem, where a firm chooses a cost-reducing investment before price is subject to regulation. In a standard scheme, investment will be lower than required by efficiency. If the possibility of negotiation is taken into account, we then show that this undercapitalisation result can be reversed. Indeed, with sunk costs we can observe excessive capitalisation.