Dynamics of Yardstick Regulation: Historical Cost Data and the Ratchet E ffect

Real life applications of Yardstick Regulation frequently refer to historical cost data. While Yardstick Regulation cuts the link between fi rms own costs and prices firms may charge in a static setting, it does not in a dynamic setting where historical cost data is used. A fi rm can influence the price it will be allowed to charge in the future if its behavior today can e ffect future behavior of other fi rms that determines the price this fi rm will be able to charge later on. This paper shows that, assuming that slack, infl ating of costs, is bene cial to fi rms, a tradeoff between short term profit through abstinence from slack and the benefit of slack in (in finitely) many periods arises. A ratchet eff ect that Yardstick Regulation was meant to overcome can occur and firms can realize positive rents because of the use of historical cost data, even if firms are identical. Equilibria with positive slack can exist without any collusion between fi rms or threat. Moreover, this problem is more severe if the fi rm with lowest costs of all other firms instead of the average fi rm is the yardstick.