REGULATION WITH 20-20 HINDSIGHT - HEADS I WIN, TAILS YOU LOSE

Regulators are commonly accused of using 20-20 hindsight to punish a firm for bad outcomes rather than bad decisions; it is often thought that such penalties lead to underinvestment by the firm. I find that this expectation is not borne out when retrospective review is based on the firm's avoided costs. In a Joskow-type model, hindsight review mitigates the firm's tendency to build oversized risky projects, moving the firm closer to the cost-minimizing level of investment. In a rate-of-return model, the firm's allowed rate of return may have to be increased to keep expected profits nonnegative. If this is done, hindsight review does not affect the firm's investment level, but it does correct the (risk-neutral) firm's tendency to pay an excessive premium to eliminate construction cost uncertainty.