This paper considers the regulated monopoly that pads or falsifies its costs to increase the cost reimbursement it receives from the regulator. Contrary to the standard literature on cost regulation, the firm engages in cost reducing investment before it enters into a regulatory contract. This pre-contractual investment in cost reduction determines the firm type at the contracting stage. The paper derives both the optimum incentive compatible falsification contract and the equilibrium type distribution. With the distribution of cost types determined endogenously by the pre-contractual investment choice, an increase in the cost of falsification has two effects. First, there is a direct effect that reduces cost padding because it becomes more expensive to do so. Second, there is an indirect effect that increases cost padding because the firm responds by choosing lower investments, and lower investments are associated with more cost padding. It is demonstrated that the direct effect will dominate and both expected levels of cost padding and expected costs for falsification will be reduced. However, the indirect effect increases real costs and, despite the reduction in cost padding, the net effect can reduce welfare. It is determined that these conclusions are significantly different from those obtained when the distribution of cost types is exogenously fixed.
