Confusing fixed and variable costs under Ramsey regulation

Abstract

Ramsey regulation, in the context of tariff rebalancing, is analyzed when the regulator is not fully informed about the cost structure of the firm. It is shown that even if the estimated relation between variable costs of the two goods produced is correct, errors regarding the composition of a given total cost between fixed and variable elements result in: (i) the price of the good with a higher (lower) elasticity of demand decreases (increases) as the estimated fixed cost is higher; and (ii) whatever mistake is made, i.e., under or over estimating fixed costs, the profits obtained by the regulated firm are lower than intended.