Consumer Standards as a Strategic Device to Mitigate Ratchet Effects in Dynamic Regulation

• DOI: http://doi.org/10.1111/jems.12104
• Author: Raffaele Fiocco,Roland Strausz
• Date: 01 September 2015
• Published date: 01 September 2015

Consumer Standards as a Strategic Device to

Mitigate Ratchet Effects in Dynamic Regulation

RAFFAELE FIOCCO

Department of Economics

University of Mannheim

L7, 3-5, D-68131 Mannheim Germany

raffaele.fiocco@uni-mannheim.de

ROLAND STRAUSZ

Institute for Economic Theory I

Humboldt-Universit¨

at zu Berlin

Spandauer Str. 1 D-10178 Berlin Germany

strauszr@wiwi.hu-berlin.de

Strategic delegation to an independent regulator with a pure consumer standard improves dy-

namic regulation by mitigating ratchet effects associated with short-term contracting. A pure

consumer standard alleviates the regulator’s myopic temptation to raise output after learning

the firm is inefficient. Anticipating this tougher regulatory behavior, efficient firms find it less

attractive to exaggerate costs. This reduces the need for long-term rents and mitigates ratchet ef-

fects. A welfare standard biased toward consumers entails, however, allocative costs arising from

partial separation of the firms’ cost types. A trade-off results, which favors strategic delegation

when efficient firms are relatively likely.

1. INTRODUCTION

Ratchet effects associated with short-term contracting due to limited regulatory commit-

ment represent one of the major practical problems in dynamic regulation.1Intuitively,

the ratchet problem follows from the regulator’s inability to commit not to use against the

firm in the future any cost information inferred from the firm’s actions in earlier periods.

In the absence of commitment, the regulator succumbs to the temptation to expropriate

the firm’s rents after learning such new information. Anticipating that it jeopardizes

future rents, the firm is less inclined to disclose its information. This reluctance to reveal

information reduces social welfare.

This paper investigates the scope for strategic delegation to an independent reg-

ulatory agency in a dynamic regulatory framework with ratchet effects. We show that

establishing a regulator with a mandate that assigns a lower weight on firm profits

than the legislators’ preferences acts as a strategic device that mitigates ratchet effects.

This mandate places more emphasis on rent extraction and induces the regulator to be

tougher toward the firm. The optimal regulatory objective exhibits a zero weight on

We thank the coeditor and two anonymous referees for their constructive comments and suggestions. We

are grateful to Helmut Bester and Mikhail Drugov for helpful discussions and remarks. We also thank the

participants at CRESSE Conference in Crete 2012 and CCRP Workshopin Vienna 2012. Financial support by

the DFG (German Science Foundation) under SFB649 is gratefully acknowledged.

1. For a deeper discussion on diverse regulatory commitment problems, we refer to Levy and Spiller

(1996) and Newbery (1999).

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume24, Number 3, Fall 2015, 550–569

Consumer Standards as a Strategic Device 551

profits, and therefore the regulator is assigned a pure consumer standard.Hence, a pure

consumer standard improves the dynamic efficiency of short-term regulatory contracts.

In contrast, we do not find any beneficial strategic delegation effect of a more lenient

regulator.

Prima facie, the result that a tougher regulator mitigates ratchet effects seems coun-

terintuitive. Since the ratchet problem implies that the regulator is unable to hand out

long-term rents, standard intuition would suggest that, if strategic delegation is to mit-

igate ratchet effects, then it can do so only via a regulator who is less eager to extract

rents. This reasoning would lead to the opposite conclusion that the regulator should be

more lenient with the firm.

Our analysis shows that this intuition is misleading, because it neglects a crucial

driver of the ratchet problem: the regulator’s temptation to raise the firm’s output after

learning it is inefficient. Toillustrate our results, we consider a two-period version of the

seminal Baron and Myerson (1982) monopoly regulation model, where a firm has private

information about its time invariant marginal costs. A fundamental insight of the Baron

and Myerson model is that the firm’s private information leads the regulator to trade off

allocative efficiency against rent extraction. The reason why tougher regulation helps to

mitigate ratchet effects is directly related to this fundamental trade-off. A regulator with

full commitment powers can optimally refrain from using the pertinent information and

commit to an ex post inefficiently low output of the inefficient firm in order to reduce

the socially costly informational rents to the efficient firm. However, a regulator who

can only use short-term contracts succumbs to the temptation to raise the output of the

inefficient firm after learning its private information. This myopic regulatory behavior

triggers the ratchet problem, because the efficient firm anticipates a higher output for

the inefficient firm, and therefore it expects to receive higher rents in the second period

if it claims to be inefficient in the first period. A regulatory objective with a lower profit

weight reduces the regulator’s temptation to raise the inefficient firm’s output, because

the lower profit weight induces the regulator to place more emphasis on rent extraction

via a downward output distortion. This limits the need for long-term rents to the efficient

firm and mitigates ratchet effects. Hence, rather than restoring the regulator’s ability to

hand out long-term rents, it is preferable to mitigate the ratchet problem by assigning

the regulator a pure consumer standard that reduces the need for long-term rents. This

explains our result that tougher regulators improve the dynamics of regulation in the

presence of ratchet effects.

Strategic delegation with a pure consumer standard entails, however, allocative

costs because it induces partial separation contracts that create a partial “mismatch”

between the firm’s cost types and contracts. Hence, a trade-off results, which shifts in

favor of strategic delegation with the likelihood of the efficient firm. Strategic delegation

is therefore optimal when the efficient firm is relatively likely. Otherwise, a regulator

with an unbiased welfare perspective is preferable.

Our results are consistent with the mandate of modern independent regulatory

agencies that focus their attention on consumers, while downplaying the role of profits.

For example, Section 2A of the UK WaterIndustry Act 1991 states that the Water Services

Regulation Authority “shall exercise and perform the powers [...] to further the consumer

objective,” while mentioning with regard to firm profits that the Authority’s duty is “to

secure that companies [...] are able [...] to finance the proper carrying out of those

functions.” Consequently, profits are viewed only as an indirect mean for regulators to

achieve their primary goal of serving consumers. Similarly, Ofgem, the UK Office of

the Gas and Electricity Markets, states that “protecting consumers is our first priority,”