Regulating Without Cost Information: A Comment; Further Observations

Sappington and Sibley (1988) designed an anonymous mechanism called ISSM in order to constrain the monopoly position of the regulated firm. Their results indicate that the firm will price at marginal cost levels, have its profits held arbitrarily close to break-even levels, and still have incentives to innovate. However, further analysis shows that, in an environment characterized by factor price inflation, the firm actually will incur profit losses that may imply insufficient surplus to generate socially optimal levels of investment. The analysis demonstrates that, despite the ability to subsidize and tax the firm, ISSM forces profit losses or waste to occur in periods in which factor prices are rising. The problems due to nonrandom cost changes that generally plague anonymous mechanisms also affect ISSM. In a reply, Sappington and Sibley demonstrate that the ISSM regulatory mechanism, or a slight variant of it, performs well even when there is an exogenous increase in the costs of the regulated firm.