REGULATORY INCENTIVE POLICIES AND ABUSE

We examine the incentives for abuse under rate-of-return (ROR) and inc remental surplus subsidy (ISS) regulation. Abuse consists of expenditu res by the regulated firm that provide private benefits, but do not re duce production costs. We show that ISS regulation provides efficient incentives for owners of the regulated firm to limit abuse by subordin ates. We also prove that abuse by owners of the firm will generally be greater (smaller) under ROR regulation than under ISS regulation when consumer demand for the regulated product is inelastic (elastic). Fur thermore, we show that to limit abuse and improve welfare under ROR re gulation, it can bo advantageous to ''ignore'' available information a bout consumer demand.