EFFICIENCY-IMPROVING INVESTMENT AND THE RATCHET EFFECT

In a long-term relationship between a regulator and a firm the product ion technology may change due to investment. This paper investigates h ow the introduction of such an investment possibility influences the d ynamic regulation problem when long-term commitments are infeasible. C ontractible investment is shown to reduce the ratchet effect by increa sing separation in the first period. Due to the separation effect of i nvestment, the first-period optimal scheme converges toward the optima l scheme with commitment as investment increases. Finally, assuming no ncontractible investment, the paper analyzes the relationship between separation and the degree of under-investment.