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Research and Development of an Optimally Regulated Monopolist with Unknown Costs

SAGLAM, ISMAIL (2014): Research and Development of an Optimally Regulated Monopolist with Unknown Costs.

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Abstract

This paper studies whether a monopolist with private marginal cost information has incentives to make cost-reducing innovations through research and development (R&D) when its output and price are regulated according to the incentive-compatible mechanism of Baron and Myerson (1982). Under several assumptions concerning the cost of R&D and the regulator's beliefs about the marginal cost, we characterize the optimal level of R&D activities for the regulated monopolist when these activities are observed by the regulator as well as when they are not. We show that the regulated monopolist always chooses a higher level of R&D activities when its activities are unobserved. In situations where the social welfare attaches a sufficiently high weight to the monopolist welfare, the monopolist's R&D activities in the unobservable case even realize at a higher level than its activities when its output and price are not regulated. Moreover, whenever R&D activities increase productive efficiency, a less efficient monopolist would choose a higher level of R&D activities than a more efficient monopolist, irrespective of the observability of R&D.

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