Regulation with "20-20 Hindsight": Least-Cost Rules and Variable Costs

Regulators sometimes review a regulated firm's input decisions in retrospect (i.e. with "20-20 hindsight") and punish bad outcomes rather than bad decisions. When such practices are applied consistently to contracts for variable factors in a regime with profit regulation, the firm increases its capital stock and relies more heavily on spot market purchases for its variable inputs; the firm's profits are reduced, but welfare effects on consumers are ambiguous. If applied as a type of "stochastic price cap" regulation, however, hindsight review can induce variable input choices that minimize expected costs.