Trigger Price Regulation

We consider the difficulty of achieving efficient prices and investments when returns on a public utility's projects are vulnerable to opportunistic ratemaking. We model the long-term relationship between a firm and its regulator as a time-dependent supergame in which the regulator sets price ceilings to maximize surplus and the firm invests to maximize profit. We find history-dependent strategies that support self-enforcing, mutually beneficial equilibria. Equilibrium payoffs are close to the planning solution provided interest rates are small enough and capital depreciates fast enough. We concentrate on "trigger price regulation" where, in response to inefficient behavior, the regulator cuts price down to operating cost and the firm curtails investment. This mechanism performs well even with production economies and with restrictions on players' threats.