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Incentive Structures in the Presence of Subsidies: Optimal Contracts in Infrastructure Utilities

Jun 2004
Stanford King Center on Global Development Working Paper
By  Saugata Bhattacharya, Urjit R. Patel

A significant source of uncertainty for utilities and regulators, especially in developing countries where they are pervasive in one form or the other, is the level and timing of subsidy transfers, which also act as a wealth constraint on the utility. The paper explores the properties of “menus of incentive contracts” that may be offered by a utilities regulator in the context of the hitherto unexamined interaction between subsidy delivery and regulation. These menus normally are designed as revelation mechanisms to incentivize self-screening by utilities with different cost characteristics by endogenously revealing information about them; depending on the asymmetry, both pooling and separating equilibria emerge. The paper shows that menus which are in current use are unlikely to achieve separating equilibria with multiple sources of information asymmetries, for example, when uncertainty over subsidy payments is introduced.

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