Optimal risk allocation for regulated monopolies and consumers

The model shows how a regulated monopolist's price should change as random cost and demand parameters are revealed. The regulator has a Ramsey-type problem. With a linear tariff a trade-off between allocative efficiency and risk sharing typically exists. The attitudes of the consumer and the firm to both income and price risk determine how the price should move. Sufficient conditions are found for price adjustment schemes used in practice to be optimal. These schemes include full, partial and zero pass-through of marginal costs, and price caps, average cost pricing and caps on total revenue for demand risk. (C) 2002 Elsevier B.V. All rights reserved.