Optimal revenue adjustment in the presence of exogenous demand variation

Abstract

This article examines optimal adjustments to a regulated firm’s revenue when realized revenue diverges from expected revenue due to exogenous variation in demand. The adjustments that are considered include those that arise under two popular forms of incentive regulation — price cap regulation (PCR) and revenue cap regulation (RCR). It is shown that the optimal revenue adjustment reflects the firm’s Lerner Index. The optimal policy differs from both PCR and RCR, but more closely resembles PCR (RCR) when the prevailing fixed charge for the firm’s service is large (small).