Wearing out the regulator: Industry response to non-credible high-powered regulatory regimes

Although widely applied in Europe, incentive regulation for infrastructure rests on scant empirical evidence. Most firms under price-regulation are constrained to cost minimization and cannot reveal preferences for other rent-seeking behaviour. Further, the type of methodology used for the determination of the price- or revenue cap has not been subject to specific empirical analysis. We study the behaviour of firms under ex post lighthanded regulation in transition to a high-powered regulation. Rather than traditional cost-function estimations, we use decompositions of profitability, revenue and cost changes. Profitability variations across time per firm are decomposed in total factor productivity and price recovery effects. The contribution of input and output quantity and price changes are used to determine total factor productivity (TFP) development, in its turn estimating the factor contributions to profitability. In addition, we decompose TFP economically in technical, efficiency change and scale effects. The data is a panel of 132-137 firms operating 241-247 concession areas for electricity distribution in Sweden during the period 2000-2006. We show that in anticipation of the fall of the Swedish engineering cost model, the firms strategically retained their cost levels and slowed down technological progress, both towards earlier periods and neighbouring countries.