Carrot and Yardstick Regulation: Enhancing Market Performance with Output Prizes

Abstract

The fundamental objective of most regulatory mechanisms is to expand output at a sufficiently low cost to consumers. Many useable mechanisms, such as Loeb and Magat's, require detailed demand information and substantial profit recapture by the regulator in order to achieve this objective. We present an apparently unexplored alternative approach--inducing competition among firms for shares of a monetary reward. Payments to a firm for output expansion thus depend on both its own behavior and the actions of other firms, which can even be firms in unrelated industries. We show that in a wide variety of circumstances, the resultant increase in consumer surplus exceeds the reward. Hence, even with no profit recapture, our approach can lead to Pareto improvements.