Microeconomics: Policy
Reading assignment Nov24
1. What the regulator has to know about costs in
order to implement the yardstick competition?
• The cost levels of similar firms 𝑐
• The cost-reduction expenditures of similar
firms (𝑅(𝑐))
– Or some other data that contains this information,
for example, accounting data
• After observing these, the regulator can set
the price and the transfer according to specific
rules (question 2)
Juhani Koskinen
Joona Widgrén
2. Pricing and Transfer under yardstick competition
Ø It is in regulators interest to eliminate the dependence of firm’s price on its
own chosen cost level
Ø This dependency leads to inefficiency as seen in cost-of-service regulation
Ø Regulator uses the cost levels of identical firms to assign each firm its own
shadow firm that works as a benchmark for the cost-level and costreduction expenditure:
à Mean marginal cost of all other firms
à Mean cost-reduction expenditure of all other firms
Ø Regulator achieves social optimum as a unique equilibrium by committing
himself to the price and transfer rule given by
Jussi Järvi 596161&Risto Hurmeranta 586168
3. Why cost of service regulation does not yield the social optimum?
• In cost of service regulation regulator sets prices equal to marginal costs and any lump sum transfers equal to
the price of investment to reduce costs.
• Under this regulation profit of monopoly is zero with or without cost reduction, and manager of the
monopoly has no incentive to reduce the costs.
• The cost and prices remain high and the output remains low.
4. Explain the incentives that make the yardstick competition to work
• In the yardstick competition model the price is set to equal the mean costs of similar firms.
• If the firms cost are higher than the mean, the firm loses money and has incentives to reduce costs. That is if
the regulator can credible threat the bankruptcy of the unefficient firm.
• If the firms cost are equal to the mean cost or lower, the firm still has incentive do decrease costs as this
maximizes its profits.
• Essentially yardstick competition removes the connection between the prices and the price level a regulated
firm has chosen for itself.
Anton Nikolenko
4. Explain the incentives that make the
yardstick competition to work
• Appropriate cost level unknown to regulator
• Use identical firms as a benchmark
• The model
– N ≥ 2 firms
– For firm i:
𝑐𝑖 =
1
𝑁−1
𝑗≠𝑖 𝑐𝑗
𝑅𝑖 =
1
𝑁−1
𝑗≠𝑖 𝑅𝑗
• Firms can profit by reducing costs
• Nash equilibrium at social optimum c*
Microeconomics: Policy
Reading assignment Nov 24
Kalle Piiroinen, 69267P
5. What is “Reduced form” regulation?
• When there is no identical firms to use, the regulator can, if observing the charachteristics that
makes the firms differ, correct for heterogenity and then apply yardstick competition
• ϴ- firm specific observable exogenous charachteristics
• The correction amounts to a regression of costs on charachteristics that determine diversity
• Similar to the normal form the firms best
• Is given by
• By running a Taylor approximation we get:
• W
estimate (25) by data on costs and firm
specific charachteristics
Janna Öberg
6. ECONOMETRIC CHALLENGES OF “REDUCED
FORM” REGULATION-JOONAS MUSSALO
•  Not all heterogeneity between the firms is not accounted for (the firms have
characteristics that makes the companies differ)
à outcome diverges from the optimum
•  The model assumes that all omitted exogenous characteristics are
uncorrelated with theta in the regression
•  If not à Omitted variable bias on estimated coefficients:
•  If some variable is omitted that affects one company’s costs differently
than the other company’s
•  Theta is assumed to be exogenous
•  But firms may actually have control over some of the characteristics of
theta
•  But of course: the reduced form regression can be estimated even if the
coefficients are biased and get a close to optimal
If the firms are not identical, and “reduced form” estimates do not account
for heterogeneity completely & correctly à the outcome might be biased
and not efficient
WANG Yue
7. Collusion and yardstick regulation
Yardstick regulation
Collusion
• Each firm competes with its
• Firms realizing they are
played out against each
other may take measures-collusion.
• Slow down cost reduction
without losing money
• Limited by:
① punishment
② sustainability
shadow firm(s).
① Firm A profits
A：raise P
Shadow firms: remain P
② Firm A loses
A: remain P
Shadow firms: decrease P
Sankwa Chikumbe
13. Can you think of practical cases implementing yardstick competition?
 Regulating firms on basis of relative performance is known as yardstick
competition.
Examples;
1. Medicare in USA.
 Uses Prospective Payment System (PPS) used in US Medicare
(Shleifer, 1985) and the regulation of
 A Prospective Payment System (PPS) is a method of
reimbursement in which Medicare payment is made based on a
predetermined, fixed amount.
 The payment amount for a service is derived based on the
classification system of that service (for example, diagnosisrelated groups for inpatient hospital services).
2. Fertilizer Market in Zambia
 Fertilizer distribution have a predetermined cost that is set by
Ministry of Agriculture Board.
 The payment is made per the number of farmers catered by the
distributor.
13. Can you think of practical cases implementing yardstick
competition?
Dublin Airport Authority attempted yardstick competition but
abandoned it (Reinhold et al., Journal of Air Transport
Management, 2010)
Choice of comparable companies was difficult
Operational efficiency differences within the peer group were
difficult to explain and translate into achievable targets
Nowadays a simple price cap in use, derived from projected
passenger numbers and costs
A somewhat similar form of regulation: rate-of-return
regulation of electricity grids in Finland
A “reasonable rate of return” calculated with WACC using
parameters from the market and a set of comparable
companies
This is compared to the actual profit, resulting in a balancing
transfer (to either direction)
The steering instrument is accounting profit
However, there is a “yardstick element” in WACC (peer group
capital costs)
Ville Potka
A theory of yardstick competition
13. Can you think of practical cases implementing yardstick competition? • Energy network
• Finland has 80 electricity distributors in Finland
• Regulator set prices based on average production costs • Actual costs allowed to deviate from reference value, • Railway network
• Evaluate operating costs and rail operators’ performance
• Prevent inefficiency
• Open up for competition in 2017...?
• Hospitals
•
•
•
•
Pre-­‐determined price per patient in a specific group
Fixed price for a patient, hospital bears the cost of treatment
Incentive to minimize costs
Demand depends on quality
Marita Koskinen