Yardstick competition to elicit private information: An empirical analysis of the Japanese gas distribution industry

This study examines the effect of yardstick regulation in Japan's gas distribution sector, especially focusing on its effect of reducing the adverse selection problem. The Japanese government has regulated the price of city gas supplies by a combination of fixed-price regulation and ex-ante yardstick regulation. The yardstick compares a firm's reported costs with those of 'similar' firms before the price is determined. Realizing that yardstick inspection will lead the industry to a full-information outcome if it works perfectly, we infer its effect from the difference between the current and the counterfactual full-information welfare levels. We estimate the cost function of retail gas distributors under the assumption of asymmetric information between the regulator and the distributor in the efficient level of labor. The estimation allows us to obtain informational parameters such as firms' efficiency levels and effort levels. Using the estimated cost structure and the firms' behavior in response to the regulatory incentive, along with the demand system and the behavior of the regulator, we calculate the current and the hypothetical full-information welfare levels, and examine whether the discrepancy of the current level from the full-information one has been significantly reduced since the introduction of yardstick regulation. Our results suggest that, on average, yardstick regulation reduces welfare discrepancy, implying it is somewhat effective in reducing firms' incentive to report higher costs. This effect, however, comes mainly from the very first inspection conducted in 1995. There seems to be a dynamic problem, similar to the Ratchet effect, because subsequent inspections cannot be effective for a firm that has learned the relative position of its own cost in the comparison group.