Diversification by Regulated Monopolies and Incentives for Cost-Reducing R&D
Abstract
the regulator is able to reduce the regulated revenue requirement due to the cost savings resulting from economies of scope, then some of the benefits of joint production ultimately may be passed on to the consumers of the regulated products in the form of lower prices. Diversification into unregulated markets also increases the firm's incentives to engage in process innovation by providing opportunities for earning profits in unregulated markets. Investments in process innovation can lead to lower future costs of producing the regulated product and potential future price reductions to regulated customers. I present a model of the firm's decision to diversify into an unregulated market and look at the implications of that decision for a firm's incentive to innovate and for consumer welfare. The firm's choice is strongly influenced by the extent to which the regulator reduces the amount of fixed cost included in the regulated revenue requirement should the firm choose to diversify. I show that if the regulator is able to observe production costs accurately at the time of a rate review, then diversification increases the firm's incentive to innovate and leads to higher gains in consumers' welfare over time.
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