EFFICIENCY-IMPROVING INVESTMENT AND THE RATCHET EFFECT

In a long-term relationship between a regulator and a firm the production technology may change due to investment. This paper investigates how the introduction of such an investment possibility influences the dynamic regulation problem when long-term commitments are infeasible. Contractible investment is shown to reduce the ratchet effect by increasing separation in the first period. Due to the separation effect of investment, the first-period optimal scheme converges toward the optimal scheme with commitment as investment increases. Finally, assuming noncontractible investment, the paper analyzes the relationship between separation and the degree of under-investment.