Regulatory Risk underOptimal IncentiveRegulation

The paper provides a tractable, analytical framework to study regulatory risk underoptimal incentive regulation. Regulatory risk is captured by uncertainty about thepolicy variables in the regulator’s objective function: weights attached to profits andcosts of public funds. Results are as follows: 1) The regulator’s reaction to regulatoryrisk depends on the curvature of the aggregate demand function. 2) It yields a positiveinformation rent effect exactly when demand is convex. 3) Firms benefit fromregulatory risk exactly when demand is convex. 4) Consumers’ risk preferences tend tocontradict the firm’s. 5) Benevolent regulators always prefer regulatory risk and thesepreferences may contradict both the firm’s and consumers’ preferences.