Democracy and Regulation: The Effects of Electoral Competition on Infrastructure Investments

This paper investigates infrastructure investment in markets where regulation is subject to varying degrees of manipulation by elected politicians. Based on a game between a service provider, consumers with voting rights and elected decision makers we construct a model of price regulation in a market with increasing demand and long-term returns on investment. Investment is irreversible and profitable only with a sufficiently high price, thus a fear of future electoral pressure on prices may lead to inefficient delay. We investigate the price and investment dynamics through an experiment with human subjects. The experimental results show that, in contrast to the prediction, the agency problems are only a minor source of inefficiency. When decision-makers interests’ align with those of the consumers, the possibility to create independent regulation does increase efficiency, because it induces both optimal pricing and timely investment, shielded from future price manipulation. Surprisingly however, independent regulation is not efficient when decision makers align with service providers because it facilitates collusion and may serve to cement prices inefficiently high.