COMMON COSTS AND CROSS-SUBSIDIES: MISESTIMATION VERSUS MISALLOCATION

Existing models of cross-subsidization have focused on either ex ante distortions to investments or misallocations of common costs as the principal sources of cross-subsidies in regulated firms. In this paper, we identify a third vehicle for such cross-subsidization that, given regulators ’ preferences, is not only likely but likely to be prominent; namely, the misestimation of the magnitude of common costs. Because our results incorporate regulators ’ preferences, they may provide the nec-essary building block for a positive theory of the magnitude of observed common costs that has, heretofore, been absent in the literature. (JEL L51, L97) I