1 The Rationale for Performance-Based Regulation
One of the motivations for the design of new regulatory schemes is the perception of a poor cost performance of regulated firms. Depending on the situation, this poor performance may take several forms: insufficient internal control, labor hoarding, incompetent management, undue perks, lack of innovation, imprudent investments, and so forth. The suboptimal performance is generally attributed to a lack of incentives. Deregulated firms have traditionally operated under a regime in which cost increases were automatically passed through to consumers in the form of higher charges for the operators' services. Recent reforms have been trying to make firms accountable for a substantial fraction of their costs.
1.1 A Procurement Example
To get a good grasp at the incentive issues, let us abstract from pricing considerations in a first step. Suppose that a government wants to procure some (fixed amount of) public good. Only one firm has the know-how or capacity to supply this public good. Unfortunately, the government has imperfect information about the cost that will be incurred by the firm. Its expected cost depends on both exogenous and endogenous variables.
Exogenous variables refer to the technological requirements that the firm will be facing in producing the public good and to the firm's opportunity cost—that is, the profit forgone by the firm when producing the public good instead of undertaking an alternative project for another principal. To the extent that the firm is better informed about these exogenous factors when contracting with the government, as is likely to be the case, the government faces an adverse selection problem. Roughly speaking, the government does not know whether a low payment will suffice to convince the firm to undertake the project or whether it will have to "pay the high price." Needless to say, the firm will not be eager to reveal that its production cost is low even if this is the case, since it is in its interest to persuade the government that only a high price will do.
Endogenous variables refer to those postcontractual decisions taken by the firm that, together with the exogenous variables (and some ex post uncertainty), determine the firm's final production cost and that cannot be contracted upon because they are not verifiable by a court of law. These discretionary choices by the firm create the scope for poor performance that we alluded to earlier. That is, the government faces moral hazard on the firm's side. Only if the firm is made accountable for a large fraction of its realized cost will it not abuse this discretion.
1.2 The Basic Trade-Off between Incentives and Rent Extraction
Suppose that the government wants to buy the public good but would like to pay as little as possible. Its instrument is the payment to the firm, which can be made contingent on the firm's ex post realized cost (provided, of course, that the firm is willing to provide the public good under the conditions offered by the government). That is, the government offers a cost reimbursement rule specifying the payment that will be made to the firm for each realization of the cost.
A key concept is that of the power of the incentive scheme. A high-powered incentive scheme is one in which the firm bears a high fraction of its cost at the margin. That is, when the firm raises its cost by $1, its net payment (that is, the payment it receives over and beyond the reimbursement by the government of the realized cost) is reduced by an amount close to $1, or, equivalently, its gross payment (that is, the payment it receives if, by accounting convention, it pays the cost itself) hardly moves with the realized cost at the margin. In a procurement context, a fixed-price contract, in which the contractor receives a fixed gross payment, is the prototypical high-powered incentive scheme, since the firm is made fully accountable for its cost savings. In contrast, a low-powered incentive scheme is one in which a $1 increase in the firm's realized cost translates into about a $1 payment by the government, and so hardly affects the firm's profit. In particular, in a cost-plus contract, the firm's cost is reimbursed, and so the firm is not made accountable for its cost savings or overruns.
If the government were fully informed about the firm's cost, that is, if there were no adverse selection, the government's design of a contract for the firm would be a simple matter: by offering a fixed-price contract, the government would give perfect incentives to the firm. The latter would fully internalize its cost savings and therefore would exert the socially optimal level of effort to reduce costs. Besides, the government would not have to worry about paying too high a price. Being well-informed about the firm's technology, it could perfectly choose the fixed price so as to leave the firm with no rent; that is, it could select the lowest price that is consistent with the firm's being willing to agree to produce the public good. We conclude that, in the absence of adverse selection, the government would offer a high-powered incentive scheme.
In the presence of incomplete information about the firm's technology or opportunity cost, though, the government faces a trade-off between giving good incentives to the firm and capturing its potential rent. Recall that proper incentives for effort are created by a fixed-price contract (or more generally by a high-powered incentive scheme). But a contract that yields $1 to the firm each time the firm endogenously reduces its cost by $1 also gives it $1 whenever its cost is lower by $1 for exogenous reasons; that is, a firm is residual claimant also for cost factors that are outside its control. This fact generates substantial rents. In contrast, a cost-plus contract (or, more generally, a low-powered incentive scheme), while providing poor incentives to keep cost down, is efficient at capturing the firm's potential rent. Indeed, the firm does not benefit when it is lucky and its cost is exogenously reduced by $1, since the cost is fully borne by the government.
To illustrate this adverse selection problem and the impact of the power of the incentive scheme, suppose that there is no moral hazard problem—that is, that the firm's cost is exogenously determined. This cost can be either 5 or 10. If the government is constrained to offering a fixed-price contract, and if the public good is socially sufficiently valuable so that the government must supply it, then the government has no choice but offering 10 to the firm. While this offer ensures that the firm is willing to produce the public good, it also leaves a rent equal to 5 if the firm has a low cost. In contrast, a cost-plus contract pays only what is needed to let the firm break even. To be certain, the realized cost is then, say, 8 or 13 (depending on the firm's intrinsic efficiency), but the payment matches the cost.
We thus conclude that there is a basic trade-off between incentives, which call for a high-powered incentive scheme, and rent extraction, which requires, in the presence of adverse selection, low-powered incentives.
This simple implication of the theory is too often forgotten. High-powered incentive schemes (price caps in a regulatory contract) have repeatedly been hailed as a breakthrough in the economics of regulation. While they indeed deliver a good cost performance, they are also likely to leave substantial profits to the firms' owners. There is no magic cure. Those who support or just accept the use of high-powered incentive schemes should be ready to refrain from forcing contract renegotiation when they observe large profits. Experience (the 1995 early review of the U.K. regional electricity companies is a case in point) shows that this point is not always understood.
1.3 One Size Does Not Fit All
A second insight, "One size does not fit all," can be gleaned from our procurement example. The same contract in general does not fit all types of supplier. The point is more subtle than the incentives-rent-extraction trade-off, but it is equally important. In the presence of asymmetric information between the firm and the government, the key issue for the latter is how to screen the firm's type through its contractual choice.
Recall that the difficulty encountered in extracting the firm's rent resides in the firm's ability to pretend to face a high cost when it actually has a low cost. The government can, however, reduce the gain enjoyed by a low-cost firm by making this strategy unappealing. To build a simple example, suppose that the firm's intrinsic cost can be "high" or "low" (that is, the exogenous cost parameter can take one of two values). And suppose that the government offers a menu of two contracts, a fixed-price and a cost-plus contract, from which the firm selects one (or none). The fixed-price contract is designed so as to let the firm just break even (that is, enjoy no rent) when it has a low cost. Yet the firm when it has a low cost is not tempted to choose the cost-plus contract, since its cost efficiency yields no gain under a contract that reimburses all costs anyway. And it is easy to see that the firm strictly prefers the cost-plus contract when its cost is high because it would lose money under the fixed contract, which, as we have seen, is designed so as to let the more efficient type just break even.
This menu of a fixed-price contract for a low-cost type and of a cost-plus contract for a high-cost type allows the government to ensure participation by the high-cost type while not giving rents away to the low-cost type. This "perfect screening" is of course purchased at a high expense: The high-cost type faces no incentive whatsoever to control cost. But it illustrates nicely the scope for screening
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