Sequential Equilibrium Investment by a Regulated Firm

We examine the investment decisions of regulated firms in a sequential-equilibrium model under asymmetric information. The regulator is unable to commit to a pricing policy, unlike meachanism-design models, but sets rates after observing the firm's investment. The information conveyed by the firm's investment level alleviates the underinvestment observed under full information with limited regulatory commitment. The equilibrium regulatory strategy can be characterized by a nonlinear rate-of-return schedule. A regulator announcing such a schedule would be able to make a credible commitment.