This paper uses a simple “Principal – Agent” model to study the behavior of the multi-goal firm under regulatory constraint. There then follows a discussion of how the government, by means of the multi-stage decision process, decides upon the “optimal regulated rate of return”. From this regulated rate of return, all kinds of economic effects of the firm can be analyzed.
The paper makes three important discoveries:
(1) Under the regulation rate of return, the firm’s allocation of resources will be distortioned, leading to an increase in production costs. Moreover, this will be especially so with utility maximizing firms as compared with profit maximizing firms. However, if the manager uses the differential piece-rate contract” to establish incentives for the enterprise’s personnel, such distortion can be reduced.
(2) Because of the existence of the optimal regulated rate of return, the level of production and inputs used must increase, regardless of the type of business operation the regulated firm is engaged in. In addition, due to the downward pressure on prices, net social welfare will also be able to increase.
(3) As most regulated firms are characterized by gradually increasing returns to scale, the government can by means of regulating the “differential rate of return” make the enterprise’s personnel system sound. The manager must strengthen his ability to oversee and monitor measurement in order to establish the reward-punishment system of the differentiated piece-rate contract and by this advance the enterprise’s vitality and create work incentives. Then as the enterprise’s personnel system gradually becomes more sound, the government can broaden the degree of regulation of the rate of return. The final result will partially reform the distorted allocation of resources and will also result in an increase in social welfare.
