Separation of Regulatory Powers When Contracts Are Incomplete


  • This paper derives from a chapter of my PhD thesis, therefore I would like to thank my advisor Abhinay Muthoo for very useful comments on the first draft of the paper. I am also grateful to Edilio Valentini who pointed out a way to present some of the ideas in the paper in a much clearer way, and participant to the SIEP 2006 conference at Pavia (Italy). The current version has greatly benefited from comments of the editor John Conley and three anonymous referees. Usual disclaimers apply.


The investment of a regulated firm affects the service/good provided on many dimensions. Should an integrated regulator take care of them all? Or is it better to have separate regulators responsible for them? We analyze the effect of the separation of regulatory powers on the regulated firm's ex ante incentive to invest in a “cooperative” innovation. The effects of the innovation are not verifiable and the cost of investing is sunk, hence, there is a problem of hold-up. We find that when the innovation produces opposite effects the ex ante firm's incentive to invest is larger in the case of separation than in the case of integrated regulation. We also stress the risk of over-investment that the separation of regulatory powers may induce. We maintain that along with classical incentive regulation—which mainly provides incentives for the firm to be efficient—the separation of regulatory powers may play a role in providing an incentive for cooperative innovations.