Discussion Payer No. 412 REGULATING a MONOPOLEST WITH UNKNOKN COSTS by David F. Baron and Roger 2. Myerson December 1979 J.L. Kellogg Gradyate School of Managenent Northvescern University Evanston, Illinois 60201 Abstract. We consider the problem of how to regulate a monopolistic firm whose costs are unknown to the regulator. The regulator's objective is to maximize a linear social welfare function of the coasuuers’ surplus and on the firm's profit. In the eptiaal regulatory policy, prices and subsidies are designed as functions of the firm's cost report so that expected social welfare is maximized, subject to the coasteaints that the firm kas nonnegative profit and has a0 incentive to misrepresent its costs. We explicitly derive the optimal policy and analyze {ts properties.Regulating a Menopolist with Unkacwm Cocts by David P. Baron and Roger 3. Myerson* 1, Introduction in thear classic papers Dupuit (1952) and HotelLing (1938) considered pricing policies for a bridge that had a Fixed cost of construction and zero marginal cost. They demonstrated that the pricing policy that waniwizes con- suner vell-beiag 1s to set price equal ro marginal cost and to provide a subsidy to the supplier equal to the fixed cost, so that a firm would ba willing to supply the bridge. This first-best solution is based on a number of informazional assuaptions. First, the demand function is assumed to ve known to both the regulator and to the firm. While the assumption of complete in~ formation way be too strong, the s¢oumption thet information about denend is as available to the regulator as it is to che firm does not seem unnatural. A second informational assumption is that the Eegulator has complete infor- ation ebout the cost of the fim or at least has the same information about cost as dees the firm. This assumption is unlikely to be wet in reality, since the firw would be expected to have better information about costs than would the regulator. As Weitzman (1978) has stated, “an essential feature of the regulatory environment I am trying to describe is uncertainty about the exact specification of each fira's cost function. Th most cases evea the managers end engineers wast closely associated with production will be ua- able to precisely specify beforehand the cheapest way to generate varicus hypothetical output levels. Because they are yet removed from the production process, the regulators ate lixely to be vaguet stili about a firm's cost function.” (p. 584) As this observation suggests it is natural to expect that a fira vould ave better information regarding irs costs that vould a regulator. ‘The purposeof this papex is to develop an optinal regulatory policy for the cese in which the regulator does not know the costs of the fim. One strategy that a regulator could use én the absence of full in- formation about costs ie to give the firm the title te the total social surplus and to delegate the pricing decision to the finn, In pursuing its own interests, vhich would then be to naximize the total social surplus, the firn would adopt the eae margiaal cost pricing strategy that the xégulator would have imposed if che regulator had known the costs of the firm. This approach has been proposed by Loed and Magat (1979) but leaves the equity issue uaresolved, since the firm receives all the social surplus and consumers receive none. To resolve pose that the right to the aonepoly the equity issue, Loeb and Maget pro- franchise ve auctioned auong compecing firms ag a ueans of transferring surplus from producers to consumers. ever, if there are no paper we will not assume that an efficieat auction could be conducted. Ia the abeonce of the avetion possibility, it is clear that consumers would be better off by allowing the firm co operate as a uonogolist rather than transferring the eotal surplus to the Fira, since in that case consuuers would at Jeast receive some benefit From the other producers capable of Product efficiently, an auction will not be effective. Thus, in this Rowe supplying the fien's eutput. Another approach that wight be considered to transfer surplus from producers te eoasumers would be to levy a lump-sum tax against che farm. the cost, say decline to supply the good. ‘The approach teken in this information is based on the work of design of 2 regudetory policy which tive to aisreport its cost in order when the regulator dees not know waver, it tung the risk that {f the tax ie set oo high the firm paper to regulation under asyrmetric Myerson (2979) (1981) and iavolves the recognizes that the firm may have an incen~ to obtain a gore favorable price. Anincentive-compatible regulatory policy in which the fixw has no inceative to misreport its cost can, however, be shown to be at least as good as any non-incentive-conpatible regulatory policy, so the regulator nead only consider incentive-compatible policies, That is, since the regulator does not know the firm's costs, the regulator must set the firm's price and subsidy as @ function of sone cost report from the firm, and the regulatory policy must satisfy the constraint that the fitm should have an incentive to report the information needed by the regulator. Because of this constraint, the reguletory policy can be optimal only in a constrained sense, and a velfare loss results from the anfermational asyemetty. ‘The optduat regulatory policy necessarily depends on the regulator's prior information about the firm's costs. If it is optimal for the Fira to produce, the optinal pricing rule will be shown to depead only on the regu- Jator’s information about costs, As with the first-best solution, the optinal regulatory policy mder asymmetric information is such that production is werranted only if the social benefit resulting from the optinad pricing tule is at least as great as tha “adjusted” fixed cost. In order to implement a regulatory policy, it is necessary to provide the firm vith a fair rate of information case with # return, and in Dupuit's aad Eotelling's complete constant marginal cost and a fixed cost, a subsidy equal to the faxed cost is used to induce the firm te produce. In the regulatory policy considered here, @ subsidy is used both to reward the Firw sufficiently so that it wild produce and to induce the firm co reveal ics costs. In Section 2 ve define the basic nodal used to describe the rogulator’s problem and ia Section 3 ve analyze that problem and derive the optima]regulatory policy. In Saction 4 the general properties of this optinal policy are discussed. The special cases of known fixed costs and of inom marginal costs are discussed ia Sections 5 and 6, 2. Basie Structures To aode1 the problen of regulating @ natural monopoly vhen ite Cost structure is not known to che regulator, we could let the monopolistic Firm have costs determined by sone funetion C(q, 9), where q is the quanticy produced end 9 is a cost parameter that is unknava to che xegulater. To keep the groblem mathematically tractable, novever, we shall assume that che firm's cost function ig bilivear in q and ®, of the form (4.8) = (og # ©)8)a + eg + k,9} tf PO, and C(0,€) = 0, w u where ¢9) 1) Kg K, axe kaown constaate eatisfying c, > 0 and, > 0. 1 For mathematical simplicity, we assume that the range of possible 9 is bounded within some known interval fren & to 8) C 8 < a. Jo interpret this cost function, observe thet ky + ky3 represents Fixed cost incurred to produce any positive ourpur, and cg + 6, re~ represent the marginal cost of producing each unit after the first. For ex- ample, this formulation is general enough to include, as epecial cases, tho case of unknown aarginal costs (¢(q,8) = ky + 6q) and of unknown fixed costs (2(q.8) = @ + e99), which vill be discussed in Sections 5 and § respectively. We asoune that the firm kmewsthe true value of its cost parameter @, but that 9 is ace kaovn co the regulator. Furthermore, the reguletor is not assumed to be able to audit the cest actually incurred by the fira, so that the regulatory policy cannot be based on tha true cost of the Firm.Thus, if the cegulacor asks for a cost report fron the fim, we must anticipate that the firm would aisreport its cost function whenever this was to its advantage. ‘The regulator's probleu is to decide how the firm's regulated price and subsidy should be determined, as functions of some cost report froa the Cirm. The following observation is central to the analysic of the regulator's problen: Proposition. (The revelation principle.) Without eny lose of generality, the regulator may be restricted to regulatory policies which require the fire to report its cost parameter @ and which give the firm ne incentive te Lie, Ia different contexts this revelation priciple has been discussed in several other recent pavers (see Dasgupta, Hamuond, and Maskin (1979), bard (1973), and Harris and Townsend (1981), and Myerson (1979)). To see Wily Lt is true, suppose that the regulator chose sone general regulatory policy, not of the fora described in the ptoposition. Fox each possible value of @, let ¥(8) be the cost report thet the firn vould submit IZ ics true cost parameter were @, That is, ¥(3) aaximizes the firm's expected profit, when it is coafroated with this regulatory policy and its txve cost parancter ie 9, Now consider the following new regulatory policy: ask the firm to report its cost perancter 8; thea compute #(8); and then en~ force the Tegulations that vould have been enforced in the original regulatory policy if ¥(9} had been reported there. It is easy to see that the fira never has aay incentive co lie Co the regulator ia the new policy. (Otherwise At would have had sone incentive to lie to itself in the originally givenpolicy.) Thus, the nav policy is of the forn deserihed in the proposition, and it always gives the sane outcones as the original policy. Following the Bayesian approach, we assume that the regulacer has soze, subjective prior probability disteibuties for the unknown paraneter 6, prior to receiving any cost reports from the firm, MWe let £(:) be the density funetion for this probability distribution, and we assute that £(8) 1s a continuous function of 9 with £() > 0 over the intezvat [€,, 9,] and with’ F(8) denotiag the cumlative distribution function Zor 3, The comand funetion is assumed to be kacwn by both the firm and the regulator, We let P{-} denote the inverse demand funcrien, so that P(q) is the price at which the consumers deaang the output q. Ignoring incone effects, the total value V(q) to consumers of an outpet quantity q is the area under the demand curve, given by aos vq = J Parag. @ o The conswuwers' surplus is then V(q) - qP(a}. We aesune that the regulator fas consuaer and producer surplus ob- jectives, and has three basic copulatory instruments available to achieve its objective: 1) che regulator can decide whether to allow the firm to do dusiness at all; 2) if the fira is ia business, chen its price or quantity of output nay be regulated; and 3) the fiz aay be given a subsidy or charged a tax. Now, using the revelation principle, ve may consider only regularery policies under which the firm's cost report will reveal its cost paranetar €, sothe regulatory instruments can be chosen 26 functions of 6. Thus, we shal! describe a regulatory policy by four outcome fimetions (¥,2.4.63+ to be imterpreted as follows, For any bin [0),0)], if the fire reports that ite cost parameter is 8. then r(€) is the probabilicy that the regulator will pernit che fira to do booiness at all.) since r(@) is a probability, it aust satisfy o ¢ r@@) <1. @ If che Lira does go into business after reporting 6, then p(®) will be its regulated price, and q(3) will be the corresponding quantity of output, satisfying” pia) = PCq(83). «) Finally, (6) will be the expected subsidy pid to the firm if it reports ~ an cost parameter 0- For example, if the firm would get a subsidy s°(8) if it were allowed to go iato business, but vould get no subsidy if it were not allowed to go into business, then the expected subsidy is s(@) = r(0)s'(€). If (0) 1s negative, chen st represents a tax en the fire, The firm is assumed co be risk neutral, Thus, given a regulatory policy (r,p,q)8), 1£ the firm's cost paranerer is 8, and if the firm reports 0 honestly, its expected profit 7(9) is EB) = [pBIqCA) ~ Coq + Cy024(6) - Ky - ky]xC0) + 860). @ If the Firm were to misrepresent iee cost and report 6 wien O 1s its true cost partteter, ite expected profit would be 356.8) = [2@)at6) ~ (ey + p43) ~ ky - kyS1x(@) + 0) 6) aus, to guarantee that the firm has no incentive to uisrepresent its cost, we ust have118) = ragtaun re a for all @ia [89, 0}. We assure that the regulater camnet force the firm to operate if it expects a negative profit. So the regulatory policy aust also satisfy te individual rationality condition 1a) >e @) for alt @ in 18,9,]. We say that @ regulatory policy (r,p,4,8) ts feasible if ir satisfies the four constraiats (3), (4), (7) and (3) for a1 @ in (8),8,]. Thus, vhon the regulator uses a feasible regulatory policy, the fim will be willing to submit honest cost reports and to operate whenaver parnitted. The Tegulator's problen is to find a feasible regulatory policy that aaximices social welfare, which would be specified next. iek-neutrat and have addi ively separable utility TE the consumers ax for woney and the firm's product, the net expected gain for the consumers from a regujatory potiey (2,p,4,8) would be? J Certatery ~ peoigC@) Ir - sc@))s¢8)98. 9, 0 That is, the consumers' exgected gain is the expected consuuers” surplus froa the narkerplace minas the firn's expected subsidy, which must de paid by the consumers through thetr taxes. The regulator's expectation of the firn's profit (before 6 is known} is On f* w@peceas. 80 We assune thet the regulator aaxinizes a weighted sum of the expected gains tO consuters plus the expected profit for che firn. Specifically, wa sesune that there is sone number a, satisfying o< asi, such thai the regulator's objective is to maximize3 3 Sy (1weqcaad = pCOraC0)IE(8) - 3(0)ECES + of,ireenee)a8. @ ‘0 oO 3. Rerivation of the Optimal Policy We first state and prove two omuas which provide a nore useful characterization of the regulator's problem than the definitions given in the preceding section. Lemna 1. A regulatory policy is feasible if and only if it satisfies the following conditions for 211 @ 1 [9,,8)) 0 < rt) <1, re) PQ)» PCG), @ w(8) = HO) + Q 2@rkeqa) + 48, (ao) CA) > 0. and ap HCO) (e008) # KD 2 TENE AG) + HL) Sor alt O >. «a2 Prof, First we show chat feasibility (defined by conditions G3}, (4), (2), (8)) implies che conditions in the leama, since (3) end (4) ave simply repeated fron the definition and (11) is implied by (8), we only need to show (10) and (42). Froa (1) for any § and 8 FQ) 2 0°G,8) = 30) + eG) (e,98) + &)E - a), a3) using the defiatcions (5) and (6). Thus +) (€,08) +k) (G = 8) < CB) = TG) < rOD(e,810) FRIG~ 8) GH) where the second inequality follows from the analogue of (13) with the reles of ¢ ang 9 reversed, Then (12) follews from (14), whan 6 > 6.Since x(8)(e,9(8) + %,) is a nonincreasing function of 8, it must be continuous almost everywhere in (8, 6]. Thus, if we divide (14) by (@~ 9) and take the Mait as +8, we obtain meta) = (8) Ce, (8) + KD for almost all 6, Integrating iwplies chat (10) mest noid for any feasible cegulacory policy. Conversely, wa must chow that conditions (7) end (8) ae iwplied by the conditions in the tema, Condition (8) foMavs easily from (10) and (11), since ¢, 2 0 and k, > 0 dy assunption. To prove (7), observe that (10) implies G9) = 1G) + eB r(o,a18) # HDG - 0 8 a ~ ~ * ~ = 7 -J, (20) (ey¢@@) + ky) - ¥C8) (cya(@) + yD ]08. lf 9» Othen the integrand is nonnegative (since 6< by (12), so v (8,0) 5 #{€}. If 8 <6 then che integrand is nonpesitive, but then the integral is nonnegative (cince the divection of integration is backwards), eo that (6,9) < m(0) still holds, as (7) requires. Q.E.D. Leuma 2. For any fessible regulatory policy, the social walfare function (9) is equal te : 8, J? (ae ~ beg + 248416 (8) ~ Wy ~ eye Ce) ]e(0)E(Opad - 2 = apa (8) 25) where z ~ - aE) th = 9+ OEE). (6) Proof, From the definition of 7(8) in (5), we obtain CBG CBITLH) + SS) = TUB) + Clog + 6)8)408) + ky + &,9)r(8). an) Also, using (10) from Lemna 1,ie ay J} ncoye@yaa a aS 1 EG? eOrloyaS + ered + r@)I1E@. ae) % Substituting (17) and (18) inte (9) yields 8 L* Covcacer> - pracy r(@) ~ 99) + am) £628 % a = J Cv 8) ~ f&y + ©3398) ~ Kyo %8)e(8) — (1 ~ 8 (8) £(8)49 0 * [ecq@p) ~ eq + ey216(0) - 0 ~ &j912(9)£ (086 ‘0 4, = b= ad f PPO e,g(8) + ey )e6)49_ ~~ odRC8,). % Forsula (13) then follows by straightforvard simplification. Q. Lerma 2 gives a strong suggescion as to wiat the optinal policy should be, The integrand ia (15) is maximized for each by choosing q(8) to maximize V(q(0)) ~ (eg + ey £,10))q00), aad by Letting x(@) equal one or zero depending en whether the bracketed expression is positive or negative. Then the subsidy can be chosen so that 7 satisfies conditions (10) aad (11), But this solution will not be feasible unless rhe nonovonicity condition (12) is also satisfied, and thic condition inplies thet +, (8) must be nondecreasing in 6. Unfortunately,fer sone densitges #(-), (16) need not yield a monotone 2, (+) function, with sone carefully chosen definitions, therefore, we aow construct another func tion which is Clesely related to z,(.}, but which is always monotone non- decreasing. siven 4) es in (16), Let ay(O) = 2,77) as) for any} between 0 and 1. (Notice that the cumulative distribution fumericn (8) 4s strdctly inereasing, so that it is indeed invertible}. Let e-- H@ = J ne@ae. (20) o Next, using the notation of Rockafeller (1979, page 36), let H,(6) = cone HG), ay Thar is, BO is the highest convex fumetion on the interval {0,1} satis~ fying £0) < H,(@) for all dq0,1], Since Hy is conver, it is differen tiable almsst everywhere. Then let AO =O 22) whenever this derivative is defined, and extend h_(o) by right-contia- ‘ wity ro ellos 9 Si. Finally, lee 38) = BLO). (239 The following lemma summatizes the properties of this Z,{-) fmetion that are needed to derive the optimal policy, Ls a. There exists a contiaucus function ¢ [89,8 ]>IR suck that a & (8) > 0 for all 5, %(8) 1s locally constant whenever ¢ (8) > 9, and. eo F ¢ 8. 3. f* ac@e@ecras =f > aw@zcne@ae - [7 ccareacey Re 95 * % See, *“1. for any monotone function a(.), Furthermore, %,(@) is a nondecreasing func~ tion 9f &, and if 2,(8) is a nondecreasing function of @ thea 2,(3) = 2,(8) for ali 8. Proof. The funceion G, in the Lemna is 6, (8) = 8, C@)) - H(FC@)). G_ is continuous, since Hand H, ave continuous functions. 29 construction 2 cf, 2 A. and HL ts flat (so chat H, =R is locally constant) wheaever To derive equation (24), use integration by parts to gec a 1 - LE a@rce@ - 2,18) )€(0)40 8. 8. [7 sata e@ Arm) = f 1 aces cr a a ane a ‘O oO AL = 6 OPA) BAe D - 4, 6 Creare), 0 Men observe thet B,(0) = H,(0) and H,(1) = W(0), s¢ thee G8) ~ €(8)) = 0, bocause the convex hull of a continuoas function always equals the function at the endpoints of the domaia ia IR. %,(@) ie nondecreasing because RL is the nondecreasing delivative of a convex function. If 2y{e) were nondecreasing, hes wou! ve t= R= Zien. then ay jould be convex, so that Hy Ay and bh, = ay and Bt ly Q.E.D. We can now state the optimal regulatory policy. Ler 78) and (8) be defined by (2s) PG@(a)) = 900). (26) Lat T(@) satisty 1 48 GQ) - PLSIACD) > Hy t+ FD, F@ = O28 ¥(q(3)) - (dala) < ky + ky7,(8)- QnoC and let 5) = Ue, + 2199400) Hky to - ‘B(S}4 (8) FLED 8. ~ ~ ~ +f) Frege + k,rd8. (28) 8 ‘The following theorem establishes the optimality of this policy. Theorem. The regulatory policy (F.p,4,5) given in (25) - (28) is feasible and maximizes the social welfare iuuction (9) among 211 feasible regulatory policies. Proof. First we check that the regulatery policy is feasible, using ienma 1, Conditions (3) and (4) are obviously satisfied. To check conditions (30) and (11), we subscftute (28) into (5) to obtain 7) = sp F(@)(c,¢(6) + ky)40, and 1(2,) = 0. Since %,(@) is nondecreasing, 7 (8) Is nondecreasing, end so q(9) ie non ineraasing in 8. Notice that $e (9G) = Pladal = Prt > 0 sinca ¥1(q) = P(q). (Recall (2).) Thes, the consumers’ surplus 7{q(6))-p()a(8) is noninereasing in ©, since 4(@) ie noniacreasing, and so F(6) is also non~ inereasing in 3, Thus (12) is satisfied, Now we show that the regulatory policy is optimal. ‘hen ve sub— sticure equation (24) inte formula (15), using AC) = -¥(€)(c,9(8) + x), we find that the regulator's social velfare function (9) is equal to £2 pvcqtrd = Coy + oH y(E4C@) ~ hy — yz] WEEE (23)(5. for any feasible regulatory poltey. Since C469) > 0 and [16 (6,908) +] is nondecreasing, the seccnd integral ia (29) sust ba aonnegarive for any feasible policys but chis integral equals zero (its optimal value) for the policy ,p,4,), because 2,(9), 4(3), and F(8) are locally conseast whea- ever G,(8) > 0, In the third tema in (29), (1-e)1(@,) 2.0 for any feasible poliay (since a<1), but this term equals zero (again, its ostinel value) at the policy (F,p,q,6), Finally, to optimize the first integral in (29), we want to choose each (8) so that 0 = VCE) ~ (ey # 6)2,(8)) and we want to choose each r(8) so that 2 GF VEqt@)) - Cog + €,7,(8)9008) 2 ky + HLZ,(OD, x8) + 0 if VCa(S)) ~ Ce, + C2, (09408) < ky + Kz. But these equations are equivalent to (25)-(27), since V'(q(8)) = PCa(8)), 0 (Fsb,4)5) maximizes the first integral in (29) among all feasible policies. So (F,5,a,5) maximizes (29), which is equivalent to maximizing (9). GED. 4, analysis of che Optima) Solution. Ii the regulator had complete information about the fira's costs, the optimal policy would be to ser price equal to marginal cost and to sub- sidize the firm by an auount equal to its fixed cost, unless this subsidy exceeded the consumers’ surplus in vhich case the fira would not preduce. That is, if @ wore known ¢o the regulator, the complete-information solution would be aC) =e, 0,8. ater = 28)? ep-16~ (i se vegan - p@acan > ky F&O 3(8) = GD @ ££ V(qO)) — pl@)qC9) < ky + kyo 8(6) = (kg + 8,094 (8) Ga Of course, this policy is aot feasible for the regulator when 8 is unknown, because it does not satisfy che incentive-compatibility constraint (8). The firm vould have positive incentives to aistepresent its costs, by reporting costs ligher then the crue 8. Hovever, it is instructive to compare oar optinal policy (25) ~ (28) to this complete~information solution (20) - (32). The optimal BG), q(3) and T(@) are chosen as if the regulator were applying the conplete inforattoa solation to Zq(8) rather then to 8. Since %,(8) ia greater then 8, this transformation from 9to #,(6) may ve viewed as an accommodation to the firn's incentive to overstate its costs in the complete infornation solution. There is no obvious relationship between the optinal subsidy 8(9) in (28) and the complete-information subsidy in (32), because (8) is determined by the need to prevent the firm from mis~ representing its costs, whereas the subsfdy in (32) was only designed to cover the firm's fixed costs. Another parallel between che optimal regulatory policy under uncertainty and the cenplete-information solution is that both 5(3) in (25) and p(®) in (30) are determined independenty of the demand curve, That ae, da both cases the optinal regulatory price depends only on the regulacor’s Information about the fira's costs. Since the oprimai regulated price D(@) is generally stxictly higher than the firn's marginal costs (eg + 419), and since (8) does not dependa7 on the desané curve, the optimal regulated price p(#} may in Sone cases be higher than che unregulated monopoly price py(8) determined by the usual MR = MC condition. To see that this can indeed happen, suppose kg ~ ky ~ 0 (so fixed costs axe zero) and consider 2 marginal cost cy + ¢,@ and the corresponding price (8), Since 7(6) is independent of rhe demand function, a demand function can be chosen that intersects the price axis between marginel cost and the regulated price B(#). Clearly, the monopoly price must be lower than p(o) dx this exauple, since demand is zare at p(8). From an ex post point of view, it may seem inefficient and para~ dexical for the regulator to ever force the ra to charge 4 price higher than the unregulated aonopoly price. To understand why thie may be optimal, observe that the regulator wants to encourage the firm to adsit shat it has low costs, vhenever this is true, so that a low price can be set to generate 4 large coasuzers’ surplus. But to prevent the fira from aisrepresenting its coscs when tt has low costs, the regulator either wast reward the firm with subsidies for announcing low costs or must somehow punish the firm for announcing high ceste. Such punishments may take the form of forcing the firm to chatge a price above the monepoly price when its costs are high or of not permitting the firm to produce (7(@) = 0). From this poinr of view supernonopoly prices may be seen ac a less extreme punishment than complete shut-down, since they still generate sone consuners' surplus. In general, all the regulator's instruments (F,3,9,5) ace used together to guide the firm to honestly report its cost parameter while generating the highest possibie social welfare. The optinal regulatory price p(2) is a nondecreasing function of 8, while the quantity preduced 9() is noninereasing in 9, From (27), the function T(8) is voaincreasing in 8, with F(8) = 1 for all © below the critical value 9 at which¥@ED) ~ BOOM ACE”) = ky +e FED, and with (8) = 0 (denoting shut-dowa) for all @ above 8. Differentiating (28) in the interval where r(8) =1, yields S78) = TNO = (Leg ey 6) - GLO) + TC PAD. (33) Since q'(@) $0, and siace rhe second factor in (33) is just warginal cost minus marginal revenue at q(8), 3(8) is decreasing in 8 when the regulated price p (©) {s below the monopoly price py(9} end $(5) is increasing ia 8 when B(6) >9,(@). To underscand these results, observe that the difference berwean P(O) and py(8) tends to give the Eirm som incentive to misrepresent its costs in order to obtain a price closer to the conopely price. The sub- sidy $(8) then aust vary wich 9 ac as co offset this incentive. ~~ “However, whether the subsidy is taereastag or decreasing 8, che fita's expected profit is always decreasing in@ when £(8) = 1, eieea by (20) T(@) = “(0) (egg) Fk). Consequently, if the firm hes a Low cost parameter, it will be allowed to earn a greater profit than if ir had a high cost parameter in order to provide a reward for yeporting ite lover coote, “the profit 1(@,) of 2 fire with the highest possible cost is zero, since there is no need to reward such a fim. Let us now see how our optimal colution varies with g, the weight given in the social welfare function to the firm's profits. First we aust astabLish the following basic mathenatical result, 2 corollary of. Lemma 3, Goroliery. Fer any 9in [&+3)J. 2,@ is a nonincreasing funetion 4, ° Broof. Pick any q andBsuch that O¢ o 0, and 20 /(6")(zq - 24820. Ber 3° (9) 20 and e > op As 2) ag(8) ~ &,(6) = (rBYP(G)/E(8)<0 for all 0%, 0 AY (8) = 0 for 4214, witen saplies (0) > 2g(6). QED To get a more intuitive understanding of this result, observe that, in the special casa vhen 2, (@) is increasing in 8, we have 7,0) = 2. Then, 2 (0) = 9+ (1 ~ a) FKE)/ECS) As seen to be decreasing fac. The optimal regulated price p(@) = cy + oF is thus a decreasing function of a, while 4(9) is an increasing function of a. This feature of the optimal solution nay seem counterintuitive, but it 4s due to the in~ centive problem created by the asynmetry of information, Jo interpret the welfare implication, substitute (1) and (5) inte the social funetion (9) co obtain a JL * teqcen = 66508), 9) eC) = =) (O)]ECC)GD® The verm (¥(q(3)) - C(q(6),9))r(0) is the gross surplus, and (1 - g)7(6) may=20- be interpreted as the welfare omission resulting fron e weight onaller then one given te the dirm's inrereszs, As « approaches one, the welfare ousssion goes to zero, and che optimal regulated price decreases tovards the marginal cost, which in the Limit maximizes the gross surplus. The range of cost parameters for viich the flim is allowed to produce increases with 0; that is, ¥(8) ie 2 nondecreasing function of &, for any @. To see this, recall the definition of (8) in (27), and observe that wa - renee *GqC8))q(@) 9g(8) > 9, om i? ns * white ky + 2) £0. thas 6" is an increasing function of ay where = max (8) £8) =15. The profit of the firm may be vritten as 8 ~ ~ wai = Ff Ce ¥@) + apae. Since | and 8° are both dacreasing in a, 4(9) is an increasing function of a, for any fixed 9. Thug, alchough the consumers are paying lewer prices as a increases, the firm's total reveaue must be increasing ina. For any 3, either the firm's subsidy $(§) must be increasing in a, or the price reduc~ t CGT (B)-CWGIS), 8). tion must be ascociated with an increase in operating prc The latter condition happens oply ix those cases when p(@) ie higher than che imegulated sonopoly price pyi@), so we should expect chat 5(€) is usually-21- (but not always) increasing in a, The net expected gain to consuzers, 9, i (ereqtey) - Peeracer> Fe) - S16) 1E(8)a8, 0 is a decrezsing function of ©, because the regulator is decreasing the relative weight given to this tera in his objective function as © increases. To give an overall measure of how the optimal ragulated prices vary wich a, we can compuce the expected price Ep(@): Ep@) ~ cy + oy J 1 z,Coreceres oO 1 segte, f? 2,(ee(@as ¢ fy 8, Sy ty uy of (ede + (1~a} fy F(6)49} cg te (Ee + (1-2)8,), where EO is the expected vaiue of the cost parameter. (in the above derivation, the second equality follows from Leana 3 with (8) =L; the last equality follows from integration by parts.) When the fira's interests are given no weight (c=0), the expected price is equal to the highest vossible marginal cost, €q + £,8,- Whoa the fira's interests are given equal weight with the con- sumer's interests (GL), the expected price equals expected marginal cost. Setweer these extrenes, the expected price decreases linearly in a. For the case of 1, we get 2,(9) =8, which is increasing, so by ema 3,2a ye) 200) = 9 ‘Thus, price is alvays equal to marginal cost cy + ¢,9 when aml, and our optinal solution coincides with the solution proposed by Leeb and Magat (1979), 5. The case of Known Fixed costs: An Example To illustrate our optimal solution, let us consider an example with known fixed costs. Let k, = c= 0 and ¢, = 1, 0 that O(q,8) = ky+ Og and @ veprasents the unknowm marginal cost. Suppose that 9 is uniformly distributed on {5y.8)], so £(0) = 1£(8)-95)- The optinal price function is then p(8) = 8 + (1-0) (8 - 8) = (2-a)O- (1-0), for 195,01, which is increasing in # and has tange 8, + Gra) (7921 Let us assume a linear donand function of the form a FTG) obey where b> 0 and a> 200,. Then the quantity q($) that the firm will sell if its marginal cost is 6 is given by WO) - a — didara)d ~ (1-078. This function may be interpreted ae an adjusted (inverse) desend function expressed as a function of the wargiual cose instead of the price. ‘The demand function and the adjusted denand function are represented in Figure 1. Lat us ateume that the fixed cost ky setiefies VG) ~ PEA) >k,, so that the firm will preduce for any SEL 8y,8)). The profit of the firm is Bonn Fee) =f) ate By a sfasied area below which is positive for 3¢€, and is represented by the adjusted demand function aad above the horizontal Line at 3 in Figure 1. Taus,che firn's profit from the optinal regulacory policy is equal to whet the consumers’ surplus would be if demand vere shifted to che“22am Ps FIGURE 1 Demand function, q = PF “(p)- ee: CZ Adjusted derand function, q = 4(9) 0 qe) a4236 adjusted denand function and if price were sat at marginal cost. That is, from the firm's parsvective, the optimal regulatory policy looks Like the policy of Loeb and Magat (1978) (im which the subsiay equals the consumers’ surplus) except that the demand curve has been effectively shifted by the regulator. The subsidy 6(8) paid by consuuers to the firm is fron (28) 8. ~ = ee) =f) qcayad ~~ &HUB) - 9)g10) - KD 4 where thu last tera is the operating profit of the firm. Tf ky © 0, the subsidy for the example is negative and -S(8) is represented by the cross~ hatched area in Figure 1. The net gain co consumers (¥(q(9?) - BCSde@G) - $63} is thus the upper triangle adove p(4) plus the taz (-s(8)) levied on the firn. ‘The welfare loce that results, because of the need to screen the possible mar- ginal costs that the firm might have,is the solid triangle represaated by the éifference berween the price p(8) and the aarginel cost 9. As the vedght @ accorded the firm's interests in the social welfare function is increased, the price p(6) decreases and aquale 9 at a: The adjusted danand function rotates upward as a is increased and coincides wich the semand function for O¢ (@y,$)] when a=l. Ihe subsidy paid by consumers to the firm is then Se) =f Marpasas, 6 so che firm is paid the entire surplus cepresented by the prices between 9 and @, when a=1, The welfare loss 4(8) in our exanpla is 1 oy ~ 1a) (Mee = Gea) ap = F(a @- 997,a24— Thus, as @ is inezeased, the welfare loss is redueed, but also the not consumer surplus is reduced because of the greater subsidy paid to the firm, Tor el the welfere loss is eliminated, and the solution given here is essen tially tha solution proposad by Loeb and Magat (1979) in which consumers sur- render all of the surpius corresponding to the possible nerginel costs that the firm might have. 6. The Case of Enowa Narging] Cost Consider now tha cage in whieh the regulator knows the varginel cost but does notknow the fixed cost. Let ¢) = Ky = 0 and ky = 1, so that G(a,8) = @ + cya and € is the unknown fixed cost. ‘Then B(@) = eg. and _ 1 48 Uy > 2) ze) = { 0 = % oO if %y< 2,@). where Vy = VCP e9)) — egh Meg) Tao term Vg = VCP (ey})-on? (eg) is the consumer surplus cesulting from 2 price equal to marginal cost. Since 7,(8} is nondecreasing in 6, there a exists an @” such that _ 1 af ec) re) = ‘ 0 aee> a, The subsidy paid to the fire is (owe - 6 cece 7) #5 ~ { Lo-as- and the profit of the fim is (s*-2) if oce™ Tepe a if o> a * tice that @ is nondecreasing in a, by the Corollary in Section 4. Tats regulatory policy may be iaterpreted as au auctéon in wnich the regulator offers to pay 8” to che firm if it will produce and sell its oUuEpUE at che narginal cost cy. The offer will be accepted Sf the firm has .4 cost paraneter at least as low as €” and will othervise be rejected, A welfare loss con result because the firm is not s#oved to produce if it Aas a cost parameter @ detween 6° and Vy even though the consumer surplus axceads the fixed cost. The welfare loss resulting tn our optizal policy is cero if OV, because even in the complete information solution the Firm would not have produced, If <6), che welfare loss is the difference be- tveen the subsidy 3(8) and the complete-informazion subsidy @ less the Proportion a of profir included in the welfare function, The differance AS in the subsigy is Ag + 0" -2) = 79), which is the profic of the firm under the optinel pelicy, and the velfare loss is vhs (L-a)n(8), If the cost paraneter satisfies 3" #92 The expected welfare loss is then obtained by taking the exseetation of (6) -= 26 - 7. General Two-Parameter Uncertainty In this paper, we have allowed that the regulator may be uncertain about both the marginal cost and ed cost of the fixm, provided that these two unknowns vary collinearly. (Recall (1),) Move generally, one say try to compute optiaal cegulatory policies for cost functions of the fom catk ifq>d clq3e,k) < ° fqn obere ¢ and & are random cost paraaeters (Kao by the Eire) having come general provability disteibution ox 2, although we have not been able to extend the optimal solution explicitly to this general two-patageter case, we expact that nost of the quilitative results discussed here should still be valid. Mowever, at least two of oux more technical results do not extend to the general case. We can Show examples tn which the optizal regulatory policy does involve proper randoatestion with respect to shutting dom the fina, 0 thse ¢ is strictly between 0 and 1 for sone veluee cf che cost paraneters. Also, the result that the optinal regulated price is independent of the denand curve dose not extend to the general tvo-paraueter case. For exemple, suppose that the exo cost parauevers (c,k) could be 41,0) (how costs), or (1,4) (high fixed cost}, or (3,0) (high marginal cost), ail with equai probabitity 1/3. Let demand be P(q) = 7 - 3q. For a= 0, the optinel regulatory policy is? a1, 0) ak1,9) = 2, 8,0) = 2 PU) = 1, 9C1,4) = 2, BCL,4) = 2 33,00 ac3,0) = 1, 33,9) = “1-aT- hotice that, wich lugh fixed costs, the regulator sust tandomize over whether to let the firm go into business. However, if wa raise the denand curve ts P(q) = 8 - 3q, then the optizal regulacery goldey changes to BOLO) #1, C9) = 2.33, FU,0) #1, 52,0) = 4 PCL,4) #2, gCt,4) = 2.33, FLA) s 3144) 2 4 70,0) = 3, 43,0) = 1667, 03,0) = 1, 59,0) = 0 Notice that rhe regulated prica for af mm vith high aargiaal cost changes fron 4 to J as the denand curve shifts. With the higher deman, it vecoaes more worthwhile to keep the (1,4)-type in business, even though this requires @ higher subsidy to the (1,0)-rype. Then, with a higher subsidy to the (1,0)~ type, ic is no longer necessary to ratse the price for the (3,0)+type to screen 1t frou the (1,0)-cype+ Essentially the two-patameter problem is more coaplicated because there ave incentive constraints in two directions to worry about. For example, a low-cost firm (1,0) aust act be able to gain by reporting high fixed cost (1,4), and it must also not be able te gain by reporting high oarginal cost (3,0). Of these two constraints, both are binding in our example with the lower deaaed curve, but only the first of the two constraints is binding with the higher deaand curve. The greater difficulty ia solving the general case of two-parazeter cost functions arises because of this ambiguity as to which of these directional incentive-conpatibility constraints nay be dindiag in the regulator's optia{zation problea.10. a. 12. 13. References Dasgupta, P.S., Hammond, -P.J., and Mackin, E.S, "The Implenentation of Social Choice Rules: Some Results on Incentive Compatibility,” Review of Eeonoaic Studies 46(1979), 185-216 dupuit, J. "On the Measurement of the Utility of Public Works," International Economics Papers, 2(1952), pp. 89-110, (translated by Ril. Batback fron "de la Mesure de L'Utilité’ des Travaux Publics”, Annales des Ponts at Chauseées, 2nd Series, Vol. 8., 1844), Gibbard, A. "Manipulation of Voting Schemes: A General Recule," Econometrica, 41(1973), 587-602. Karris, M. and Townsend, E-M. "Resource allocation under Asymmetric Information,” Econonetties 49 (1981), 33-bé. Hotelling, E, “The Genetal Welfare in Relation to Problews of Taxation and of Railway and Utility Rates," Seonometrica, 6(1338), 242-69. Loeb, M. and Magat, W.A. "A Decentralized Method for Utility Regulation," Journal of Law and Zeonomics 22 (1979), 399-404. Myersen, RB. "Incentive Conpatibility and the Bargaining Problea," Eeonometrica, 47 (1979) , 61-74. Myetson, RB. "Qprinal Auction Design,” Mathenatics of Operations Research 6 (1981), 58-73. Rockafellar, R.I. Convex Analysis, Princeton University Press, Princeton, New Jersey, 1970. Schnalensee, R. “Option Demand and Consumer's Surplus: Valuing Price Changes Ucder Uncertaiaty," american Econonic Review, 62 (1972), 813-824, Spence, M. "Nonlinear Prices and Welfare,” Journal of Public Economics, 80977), 1-18 Journal of Public Feonomies, Weitcman, UL. “Optimal Rewards for Economie Regulation,” american Economies Review, 68 (1978), 683-691. Weiteman, MeL, “Prices vs. Quantities," Review of Economic Studies, S40974), 497-491,FOOINOTES Graduate School of Business, Stanford Vaiversity, and J.k. Kellogg Graduate School of Managenent, Northwestera University. ithe first author's work hae boon supported by 2 grant From the National Science Foundation, Grant No. SOC 77-07251. A regulatory policy that has a pasitive probability thac there wilh be uo output aay seon unrealistic, but in the optimal regulatory policy (9) will equal one unless che consumer surplus is less then an ajustea" fixed cost, in whieh case ¥(9) =6, Tt is easy te show that if the Firm is risk-neutral thon raadonized pricing policies cannot be optizal, On the other hand, if there were uncertainty about the denand curve, then the reguletor would have to choose betweon regulating price and Lacting quantity be rendon, or regulating quantity and letting price be random. Weitzman (1974) has studied this issue in a similar context. If consumers are hanogeneous then nonlineat priciag policies like these of Spence (1977) axe not relevant. See Schwalensee (1972) for an analysie of the expected consuner eurplus as @ neasure of welfare, ~ * - * Tf Vy? B(8,) then let 6 =). If Vg < 24085} then let 8” = 8, These solutions can be verified by standard Lagrangean techniques. The key step is to linearize the ineentive-compatibility and individval-rationelity constraints by wvitang then in terns of ated, 3° = st par, and re