The Effect of Observability on the Noncontractible Investment of a Regulated Firm

We study the effect of observability on the noncontractible investment of a regulated firm with private marginal cost information. We show that the observability reduces investment, pointing to the regulated firm's prevention of ratcheting. This result, which is in line with an earlier finding of Tirole (1986) obtained in a bargaining model of procurement with two-sided asymmetric information, reveals that 'underinvestment due to observability' is independent of whether only the investing firm or all of the parties affected by its investment decision have some private information.