Jeffrey S. Banks
This paper analyzes the interaction between a regulator and monopolist in the determination of the price for the monopolist’s product, where only the monoplast knows ex ante its true marginal cost of production. The regulator observes the market price proposed by the monopolist and decides whether to hold a rate hearing, where suck a hearing is a costly means of verifying the monopolist’s marginal cost. Subsequent to a rate hearing, the regulator can impose a market price for the monopolist’s product; in the absence of a rate hearing, the market price is set equal to the monopolist’s proposed price. Equilibrium behavior by the monopolist and regulator is characterized, and the degree of regulatory “activism,” as defined by the probability a rate hearing is held, is seen to vary ex post with the monopolist’s true marginal cost.