Working Paper: CEPR ID: DP4502
Authors: Gianni De Fraja; Alberto Iozzi
Abstract: Vogelsang and Finsinger?s seminal paper (Bell Journal of Economics, 1979) proposes a mechanism for price regulation with some desirable properties, such as convergence to a second best optimum. This mechanism applies to situations where quality is fixed: in practice, quality can be varied by the firm, and regulators have typically imposed constraints on the firm?s quality choice. This Paper lays a rigorous theoretical foundation to the inclusion of quality measures in the constraints faced by a regulated firm. We identify a potential pitfall in the approach taken in practice by regulators, and show that, in order to avoid it, the regulated firm should be subject to an additional constraint, which, loosely speaking, requires firms? choices not to be too erratic.
Keywords: price cap; quality regulation; RPiX
JEL Codes: L430; L510
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| regulatory framework (G38) | firm's output decisions (D21) |
| quality-adjusted Vogelsang-Finsinger constraint (D10) | firm's output decisions (D21) |
| distance constraint (Y80) | erratic choices (D01) |
| absence of distance constraint (R22) | Pareto inefficient cycles (D61) |
| combined effect of constraints (D10) | second-best optimal price-quality vector (D41) |