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ELSEVIER European Economic Review 39 (1995) 1511-1522

Efficiency-improving investment
and the ratchet effect
Dag Morten Dalen
University of Oslo, Department of Economics, P.O. Box 1095, 0317 Oslo, Norway

Received July 1994; final version received January 1995

Abstract

In a long-term relationship between a regulator and a firm the production technology

may change due to investment. This paper investigates how the introduction of such an
investment possibility influences the dynamic regulation problem when long-term commit-
ments are infeasible. Contractible investment is shown to reduce the ratchet effect by
increasing separation in the first period. Due to the separation effect of investment, the
first-period optimal scheme converges toward the optimal scheme with commitment as
investment increases. Finally, assuming noncontractible investment, the paper analyzes the
relationship between separation and the degree of under-investment.

JEL classification: D82; L51

Keywords: Regulation; Ratchet effect; Investment

1. Introduction

In a long-term relationship between a regulator and a firm the production

technology is not fixed. Investments both in physical and human capital may
trigger off process innovations which lead to lowered cost of production. Under
complete information the investment decision is straightforward: The investment
cost today must be compared with the expected cost saving tomorrow. However,
once we introduce incomplete information the investment decision introduces
additional effects. When the regulator has incomplete information about the firm’s

0014-2921/95/%09.50 0 1995 Elsevier Science B.V. All rights reserved

SSDI 0014-2921(95)00007-O
1512 D.M. Dalen/European Economic Review 39 (1995) 1511-1522

technology, he is forced to leave a costly rent to the firm. The reason is that the
regulator must secure production even in the case of poor technology. The amount
of rent left to the firm depends on the regulator’s beliefs about technology. As
investment implemented by the regulator affects these beliefs, the rent received by
the regulated firm will depend on such investment.
In Laffont and Tirole (1993, Ch. 1) cost-reducing investment, determining a
probability distribution for the efficiency parameter, is added to a static regulation
model. This is shown to introduce the additional rent-extraction effect of con-
tractible investment. An increase in investment shifts the distribution toward
low-cost parameters, for which efficiency-distortions are small. Compared to
optimal investment under complete information, this effect leads to over-invest-
ment.
In regulatory relationships the regulator is seldom able to commit himself to a
long-term contract. This lack of commitment in regulation is shown to introduce
the ratchet effect, see e.g. Freixas et al. (1985) and Laffont and Tirole (1987,
1988): If the firm by its past performance reveals efficiency, the regulator adjusts
the contract to reduce future costly rent given to the firm. Unless efficient firms
are given generous incentives early in the relationship, these firms will mimic
low-efficiency firms in order to secure future rent. However, as I will demonstrate
in this paper, if inefficient firms over time catch up with efficient firms due to
efficiency-improving investment, future information rent will decrease, thereby
reducing efficient firms’ incentives to pool with inefficient firms. The regulator
can therefore use efficiency-improving investment to thwart the ratchet effect.
The paper is organized as follows. Section 2 explains the choice of investment
technology and introduces this investment technology into the dynamic model of
Laffont and Tirole (1987). Section 3 discusses the effects of contractible invest-
ment in non-commitment regulation. This section draws extensively on Freixas et
al. (1985), and Olsen and Torsvik (1992). In Section 4 investment is assumed to
be noncontractible, and the influence of the ratchet effect on the inefficient firm’s
investment decision is analyzed. Section 5 concludes the paper.

2. The model

The general set-up of the model is close to that of Laffont and Tirole (1987),
but differs by the introduction of investment. In each of the two periods, the firm
must produce a given output at cost C, = & - e7, where e7 is the level of effort
and p, is a period-fixed efficiency parameter known only to the firm. The
efficieccy parameter belongs to the two-point set @, p>, with p > p. Define
Aj? = p - p. The regulator can observe cost but not the effort level or the value of
the efficiency parameter. He has beliefs about technology, where vr and v2 are
the probability that /3 = -p at the first- and second-period contracting dates,
 D.M. Dalen /European Economic ReGew 39 (1995) 151 I-1522 1513

respectively. I assume that investment in period 1, I, turns the inefficient firm into
an efficient one in period 2 with probability p(Z):

E[ Pz I P, = P] =PV)@+ [1 -PV)I 6, (1)

where it is assumed that p’ > 0, p” < 0, and p(O) = 0. The technology of the
efficient type is assumed to be time-independent. An interpretation of this assump-
tion is that the regulator knows the best available technology, /?, (including
organizational and ‘technical’ capabilities). Confronting a given firmin period 1,
the regulator also knows that there is a chance that the firm is not able to utilize
the best available technology. However, investment in period 1 might move an
inefficient firm to the technology frontier in period 2.
Social welfare in the first- and second-period is given by
W,=S-(l+h)[C,+z,+t,]+U,,

w,=s-(l+A)[C,+t,]+(/,, (2)
where S is the consumers’ value of output, t is the net transfer to the firm in
addition to the reimbursement of cost and investment, A is a shadow cost on
public funds, and U, is the firm’s utility, given by
u,=t,-*(e,), *'>O, $">O, *"'aO, *(e) =O for eGOO,
(3)
where 4 represents the disutility of effort.
By inserting (3) into (2), we get
W,=S-(l+A)[C,+Z,++(e,)] --AU,,

W2=S-(l+h)[C,+$(e,)] -AU,. (4)

The firm’s reservation utility is assumed independent of type and is normalized to
zero. As the firm is able to quit the relationship at any time, the contract must
satisfy the individual rationality (IR) constraint U, > 0.

2.1. The static scheme

For the purpose of comparison and in order to derive some preliminary results 1
will briefly review the optimal static scheme without investment. Because of the
complexity of the dynamic model throughout the paper I will restrict attention to
optimal linear schemes.
Given the contract t = a - bC, the firm chooses effort to maximize (3). This
leads to an effort choice e = e(b) given by a type independent incentive compati-
ble (IC) constraint, b = $‘(e>. The (IR) constraint of the inefficient type deter-
mines the constant term, i.e., a = b(( p> - e(b)) + $(e( b)). Thus the contract is
fully specified by 6, and the information rent of the efficient firm is given by
U(b) = bAp.
1514 D.M. Dalen/European Economic Review 39 (1995) 1511-1522

Given belief V, the regulator chooses b to maximize expected welfare:

max,(s-(l+h)[$(e(b))+vp+(l-v)p-e(b)]-hubdp). (5)
The optimal static slope is then given by

(1 + A)[1 - +‘(e)]; = AvAP.

From this first-order condition it is easily seen that the optimal static slope b( v>
is decreasing in the belief V. This is the foundation of the ratchet effect in dynamic
regulation: The efficient firm is only able to secure future information rent by
convincing the regulator that it is inefficient.

3. Contractible investment and the ratchet effect

I will now consider the two-period model with contractible investment, where
no long-term commitments are feasible. Assuming contractible investment means
that in period 1 the regulator can impose an investment level intended for the
inefficient type. The firm’s investment decision is whether to undertake the
investment project. We analyze the Perfect Bayesian Equilibrium (PBE), where
the players behave optimally at any history of the game, and where the updating of
the regulator’s beliefs about technology follows Bayes’ rule. The timing of the
model is as follows:

(Nl) Nature chooses technology.

(1) The regulator offers a first-period contract (a,, b, ), and specifies the invest-
ment level I.
(2) The firm either quits, or accepts the contract, chooses C, and whether to
invest.
(N2) Nature chooses the effect of the investment.
(3) The regulator offers a second-period contract (a,, b2).
(41 The firm either quits, or accepts the contract offered and chooses C,.

3.1. Continuation equilibria

In this subsection I consider the continuation equilibrium corresponding to a

given first-period scheme. According to Freixas et al. (1985) there are three types
of such equilibria: pooling, semi-separating, and separating. In a pooling equilib-
rium, the efficient firm chooses the high-cost level in period 1, C, = p - e( b,),
and sinks investment I. ’ In a semi-separation equilibrium, the efficient firm

’ The efficient firm has to sink the investment to signal inefficiency. By assumption this investment
will not affect the efficient type’s technology since this type is already at the technology frontier.
 D.M. Dalen /European Economic Review 39 (1995) 151 l-1522 1515

randomizes between high-cost and low-cost, while in a separation equilibrium, the

efficient firm chooses low-cost, C, = p - e(b,).
The efficient type’s benefit of mimicking an inefficient firm is the second-period
rent U(u,) = b(v,)Ap. To characterize the different equilibria, this rent must be
compared with the first-period cost of mimicking an inefficient type. This cost is a
function of b,:

L(h) = [al-h(P-44) - +(e(bJ)]

-[n,-b,(p-e(b,))-J/(e(b,)-AB)]
=b,AP- @(e(b,)), (7)
where Q(e) = q(e) - $(e - Ap). Under our assumptions this loss-function is
increasing in the first-period slope (Laffont and Tirole, 1993, p. 403). Note also
that L(0) = 0. Since the second-period rent is determined by the regulator’s
posterior beliefs, we also have to specify the regulator’s beliefs when observing
out-of-equilibrium costs. The following types of equilibria can be supported by
‘optimistic’ out-of-equilibria beliefs, which means that v2 = 1 if C, # p - e(b,),
and/or the firm does not invest I. When 6 is the discount factor, the different
equilibria are characterized by:

Separation equilibria:

L(b,) a S%Q)).

Semi-separation equilibria:

Pooling equilibria:

With investment level I, the minimum posterior belief of efficiency when

pooling occurs is given by probability p(l). In a separation equilibrium, the
first-period cost always exceeds the corresponding maximum second-period rent.
In a semi-separation equilibrium, there is randomization so that the 10~s balances
the second-period rent, i.e., L(b,) = 61% v,), where

(1 -x>u1+ Cl- ~,)PV)

u2= (l-x)v,f(l-V,)
(8)

and x denotes the randomization probability of the efficient firm choosing low
cost.
Noting that L’(b,) > 0, and that the second-period rent is a decreasing function
of the posterior belief v2, the following result is derived:
1516 D.M. Dalen/European Economic Review 39 (1995) 1511-1522

Lemma 1. Let P,, S’S,, and S, denote the set of first-period slopes which,
respectively, pool, semi-separate, and separate at investment level I. Let I’ > I.
Then PI, c P, and S, c S,, . Further, for a given b, in the interior of SS,, the
separation probabilities satisfy, x1, > x,.

The last part of the result is found from (8): An increase in p(Z) must be
compensated for by an increase in x to support the semi-separating equilibrium at
the fixed b,. The first part of this result is illustrated in Fig. 1.
The result shows that for a fixed first-period contract, the more investment
induced by the regulator, the more separation in the first period. The reason is that
when investment increases, the inefficient type catches up with the technology
frontier with a higher probability. This, in turn, reduces future loss by revealing
efficiency. 2

3.2. The optimal first-period scheme and investment

Before studying how investment affects the optimal policy I will first briefly
characterize the regulator’s dynamic problem.
First-period expected welfare IV,, is given by

Y(b,, 1) =S- r+x,(br)(l + Q{+(e(b,)) +@-e(4))

- v,(l -x,(b,))(l +A) {+(e(b,) -0) +p+l-e(br)]

-(I-vr)(l+h) {lc,(4bI))+6+I-e(bI)}

- V+,tbI)brAP+ (1 -X,(bI))@(e(b,))]~ (9)

where x,(b,) denotes the randomization probability given investment level I.
With probability vrx, the firm has type j? and reveals it; the firm then obtains a
rent b, Afi in period 1 (seen in the last t&m in (9)). With probability v&l - x,)
the firm is a low-cost type but chooses the high-cost level; the firm then obtains a
rent equal to @(e(b,>> in period 1. 3
Second-period expected welfare is given by

W2(bl,z)=vlx,(bl)WF’+[v,(l-x,(b,))+(1-V,)]WA’(~2),
-
(10)
where _WF’ denotes the static complete information welfare when the firm is
efficient, and W A’ denotes the e x p ected static welfare under asymmetric informa-
tion and belief us. Total intertemporal welfare may now be written W(b,, I) =
W,(b,, I) + HV,(b,, I).

2
This holds also in the case with general nonlinear schemes; the set of contracts inducing separation
increases when investment increases.
 D.M. Dalen /European Economic Reuiew 39 (1995) 1511-1522 1517

PO sso SO

Fig. 1. Regions of pooling (P), semi-separation (SS), and separation (S) with and without investment.

With reference to the optimal static scheme denoted by b(v,), we can prove the
following result:

Lemma 2. Let bp be the first-period optimal scheme. (i) If b( v,) separates then
by = b( v, 1, and (ii) if the optimal first-period scheme separates, then by = b( u, >.

Proof Result (i) is given a proof in Freixas et al. (1985, Proposition 6). To see
result (ii), let x, = 1 in (9) and (10). The optimal scheme must then satisfy

11
dW
-= -(l+h) (+‘(e(b,))-1); -Av,Ap=O, (11)
db,
which corresponds to the static first-period scheme (as determined by (6)).

Using this result, we can immediately derive the following corollary:

Corollary 1. If the optimal scheme induces a separating equilibrium, an increase

in the level of eficiency-improving investment I does not affect the optimal
first-period scheme (a,, b,).

However, if the first-period scheme is semi-separating, the investment level

will be shown to influence the optimal dynamic scheme. A central conclusion in
the non-commitment model is that the ratchet effect leads the regulator to choose a

’ Note that since L(b,) > 0 for b, > 0, the first-period rent b, A/3 exceeds @,(e(b,)).
1518 D.M. Dalen / European Economic Review 39 (1995) 1511-1522

high-powered scheme in the first period. This property of the non-commitment

model is revealed by the following result:

Lemma 3. Let bs be the slope that marks the lower limit of the separating
region. If b(v,) semi-separates or pools, then b(v,) ,< b? < bS.

The first inequality follows from Freixas et al. (1985, Lemma 7), and the
second inequality is a straightforward implication of Lemma 2. The reason for this
result is that the cost of moving away from the optimal static scheme b(v,) may
be more than compensated for by the benefit of the induced increase in the
separation probability. Once the slope moves into the separation region there is no
further separation effect from an increase in the slope, and schemes with slopes in
this region must consequently be non-optimal.
Before stating the investment-level’s influence on the optimal first-period slope
I will prove the following lemma:

Lemma 4. There always exists an I * such that for Z > I *, the first-period
optimal slope equals b( vI>.

Proof Choose Z large enough such that L(b(v,)) > SU(p(Z)). Then b(vl) is
in the separating region, and consequently bf’ = b( v,).
We are now able to conclude this discussion by an intuitively appealing result:

Proposition 1. The optimal dynamic first-period slope bp, converges toward the
optimal static first-period slope, b( vl), as eficiency-improving investment in-
creases.

Since investment increases the separation region (Lemma 1) it lowers b’. Thus,
the set of candidates for the first-period optimal slope (Lemma 3) is truncated
from above when investment increases. From this result we conclude that invest-
ment reduces the ratchet-problem in dynamic regulation without commitment, and
that this in turn leads the regulator to design a low-powered first-period scheme (at
least in the limit).
Given a semi-separating scheme, the first-order condition for the investment
level is
dW
- = -(l +A)(v,(l -X,) + (l- v,))
dI

+v,{(l+A)(Ap+I-G(e))-hL(b,)} $

+ svl{yF’ - WA’( v,)} g

awA’ av
+ 6 (v,(l -x,) + (1- v,)} K$=o. (12)
 D.M. Dalen/European Economic Review 39 (1995) 1511-1522 1519

The first term represents the first-period marginal investment cost, and the last
term represents the direct benefit of investment caused by the increased probability
of turning the inefficient type into an efficient type in period 2. The other two
terms are linked to the dynamic effect of investment, and show the first- and
second-period welfare effect of increased separation. From the third term we see
that increased separation is always beneficial to the regulator, in terms of
second-period welfare. Further, if the semi-separating slope is not too high above
its first-best level, first-period welfare increases with the proportion of separating
firms. In this case the revelation effect of investment, ceteris paribus, leads to
over-investment.
If the first-period scheme is in the interior of the separating region the dynamic
effect of investment is absent, thus the optimal level of investment is given by ’
tlWA’
(1 f A) = 6,1,$(Z). (13)
2

Noting that u2 =p(Z) in a separating equilibrium, we see that the investment

level is independent of the prior belief, or. The reason is that both the marginal
cost and the marginal benefit of investment are proportional to (1 - v,).

4. Noncontractible investment

Certain aspects of efficiency-improving investment may be hard to contract

upon. In period 1, the inefficient firm may in addition to effort that reduces
first-period cost, exert other kinds of effort that increases the probability of being
at the technology frontier in period 2. Such types of effort can be search for better
ways to organize the firm, or care in choosing the specific projects for improving
efficiency. Since both the level and quality of such types of non-monetary
investment can be hard to assess, they may well be noncontractible. Assuming
noncontractibility implies that the level of investment is determined by the firm’s
incentives to invest. The inefficient firm’s benefit from investment will depend on
the expected rent in period 2, and thus the level of investment will be sensitive to
the type of equilibrium in period 1.
I assume that the firm’s disutility of effort is given by I + q(e), where
investment I may be interpreted as a non-monetary effort variable. The firm’s
utility is then U, = t, - Z, - $(e,). Social welfare is still given by (4). Note also
that the relationship between the first-period slope and the efficient firm’s cost of
mimicking an inefficient firm, L(b,), is unchanged. This is due to the non-mone-
tary assumption on investment.
Before proceeding, we notice that in period 2 an efficient firm receives rent
U(v,<ZJ> = b,(v,(Z))Ap, when the regulator believes that the inefficient firm has
invested I^ in period 1.

4 This also corresponds to the optimal level of investment with complete commitment possibilities.
1520 D.M. Dalen/European Economic Review 39 (1995)1511-1522

The inefficient firm’s first-period effort and investment decision are determined
by

maxl,,l[al -Z-3( P-e,) -Z- Wer)] +p(Z)au(40). (14)

The inefficient firm’s optimal investment, given belief, is then uniquely defined
by
1 =$(Z)SU(v,(Q. (15)
The three types of continuation equilibria in this game are characterized as in
the previous section.*Hence, denoting equilibrium investment by I * and assuming
that in equilibrium Z = Z * , the sets of continuation equilibria are:

Separation equilibria:

L(b,) a qPv*)) and 1 =p’(Z*)SU(p(Z*)).

Semi-separation equilibria:

w4 = w?v* 1) and 1 =p’(Z*)SU(v,(Z*)),

where v2 is given by (8) and 0 < x < 1.

Pooling equilibria:

JW,) G ~U(? + (I- 4P(Z*))

and 1 =p’(Z*)6U(v, + (1- ~r)p(Z*)).
From these conditions we have the following result:

Proposition 2. Let Zp*, I,:, and I,* denote the equilibrium investment in pooling,
semi-separating, and separating equilibria, respectively. (i) Then Zp* < Z,: < I,‘.
(ii) For a first-period slope in the interior of SS, we have aZsi/ab, > 0. (iii)
Finally, I,” < Z FB, where Z FB is the symmetric information, first-best level of
investment.

Proof See appendix.

The third part of this result is well known from the literature on bargaining and
regulation, and confirms that non-commitment generates under-investment. 5 In-
troducing unobservable investment into a two-period regulation model with non-
commitment shows that the degree of under-investment depends on the degree of
separation in period 1. The reason is that the regulator’s posterior belief is crucial
for determining the rent attainable by investment, and that the efficient firm’s
strategy (through X) influences this posterior belief. As a consequence, first-period

5 See e.g. Tirole (1986), and Laffont and Tirole (1993, Ch. 1).
 D.M. Dalen / European Economic Review 39 (1995) 151 l-1522 1521

investment by the inefficient firm increases with the power of the first-period
scheme (result (i) and (ii>>.

5. Concluding remarks

The aim of this paper has been to analyze the importance of efficiency-impro-
ving investment on the ratchet effect in dynamic regulation. The ratchet effect
arises because efficient firms are only able to secure future rent by mimicking
inefficient firms. In long-term relationships, a firm’s technology should be ex-
pected to improve, and in the paper I have assumed that investment in period 1
may turn an inefficient firm into an efficient one in period 2. When inefficient
firms can become efficient through investment, efficient firms’ incentives to pool
with inefficient firms are reduced. The reason is that investment moves the
regulator’s posterior beliefs about technology toward the efficient technology.
Since the second-period rent is uniquely defined by the regulator’s posterior
beliefs, investment makes it easier to separate types in period 1. More precisely,
the paper shows that investment increases the range of separating first-period
schemes, and shrinks the range of pooling schemes. Also, the set of possible
first-period optimal schemes is shown to shift toward low-powered schemes as
investment increases. When investment is unobservable, and thus noncontractible,
the inefficient firm’s incentives to invest depend on the expected future rent. The
degree of under-investment therefore depends on the type of equilibrium in period
1: The efficient firm’s strategy influences the regulator’s posterior beliefs, and thus
the amount of rent attainable by investment. This explains why investment
increases with the power of the first-period scheme.
Throughout the paper I have assumed two types of firms and that it is only the
inefficient type that may improve by investment. The analysis could be extended
to allow a more general investment technology where also the efficient firm can
improve by investment. If investment affects the efficient firm’s technology, one
would have to introduce more than two technologies in period 2. Also if the
first-period scheme separates, the efficient firm could earn rents in period 2. Thus,
the assumption may seem to strengthen the dynamic revelation effect of invest-
ment. It would be of interest to study how this affects optimal policy.

Acknowledgment

I am grateful to Nils-Henrik v.d. Fehr, Steinar Holden, Jean-Jacques Laffont,

Jon Vislie, and two anonymous referees for helpful comments on earlier versions
of the paper. I am also grateful to Norges Forskningsrid (NFR) for financial
support.
1522 D.M. Dalen / European Economic Review 39 (I 995) 1511-1522

Appendix: Proof of Proposition 2

If the first-period scheme separates, optimal investment I,* is given by

- 1 +p’(Z,* )6U(p(Z,* 1) = 0. If the first-period scheme semi-separates (0 < x <
l), the posterior belief of an efficient firm, given investment, is higher than in the
separating equilibrium, implying that - 1 +p’(Z,* )SU(v,(Z,* )) < 0. If the first-
period scheme pools, the posterior belief of an efficient firm, given investment, is
even higher, implying that - 1 +p’(Z,‘)6U(v, + (1 - v,)p(Z,f 1) < 0. Given that
p“(Z) < 0, part (i) of the result follows.
In the interior of SS, the second-period rent is equal to L(b,). Noting that
L’(b,) > 0, part (ii) of the result follows.
With complete information, optimal investment is determined by the following
problem

max e,A?J (S,-(l+h)[p-e,+Z+9(e,)]

++, - (1 +A)[ p(Z@+ (1 -P(Z))&3 + +(e,)])). (A-1)

Optimal investment is characterized by
1 = Sp’( Z”) dp. (A-2)
With incomplete information, the maximum posterior belief, given high-cost
observation in period 1, is p(Z *) E (0,l). Observing this, we know that a
first-period inefficient type always faces a second-period slope b, < 1, which
leads to part (iii) of Proposition 2.

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