Information Rent and Technology Choice in a Regulated Firm

Regulated firms are not necessarily willing to invest in cost minimizing technologies, but evaluate different technologies according to their impact on the information rent. In a two-type adverse selection model three kinds of investments are considered: investments that increase the probability of having low costs; investments that reduce the cost of low-cost types; and investments that reduce the cost of high-cost types. If the investment costs are negligible and the regulator can commit to regulatory mechanisms before the firm invests, the firm will pick the first-best (cost minimizing) technology. This will also be the outcome without regulatory commitment as long as the investments are unobservable. If observable investments are sunk before the regulatory scheme is set up, the firm has generally weak incentives to invest, as well as distorted incentives regarding what type of investments to undertake.