COST PADDING IN REGULATED MONOPOLIES

In this paper we consider a regulated monopoly that can pad its costs to increaseits cost reimbursement. Even while padding is ineácient the optimal incentivescheme tolerates some padding of costs to reduce the information rents paid tolow cost types. It is shown that high cost ßrms pad costs more than low costßrms. We also show that cost padding moves pricing away from Ramsay optimalpricing toward more monopolistic pricing rules. We show that when auditing oftotal costs is costly, low cost ßrms face a ßxed price contract and engage in no costpadding. High cost ßrms do less well but do engage in padding to increase theverißed cost. If padded costs can be audited at some cost, low cost types engage incost padding but high cost types do not. We also endogenize the distribution of costtypes by allowing ßrms to engage in a pre-contractual, non-observable or verißablecost-reducing investment...