A modified yardstick competition mechanism

This paper expands Shleifer's (Rand J Econ 16:319-327, 1985) theory of yardstick competition and develops a modified yardstick competition mechanism (MYC), where the yardstick employed consists of a tariff basket and total costs. This mechanism has a significant information advantage: the regulator "only" needs to observe total costs, prices and output of all firms. The MYC mechanism can ensure a socially optimal outcome when allowing for spatial and second degree price discrimination. We also introduce regulatory lags to the model. In addition, we compare the two approaches for the case of unobserved firm heterogeneity, and provide numerical estimations of the effects. The MYC mechanism fares better in the case of unobserved heterogeneity, and may thus be a useful extension of Shleifer's yardstick mechanism.