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 model of price regulation in a market with increasing demand and long-term returns on investment we construct a multi-period game between a service provider, consumers with voting rights and elected decision makers. In each period the consumers elect a decision maker who may then regulate the price for service provision. Before an election the service provider chooses whether to increase its capacity. Investment is irreversible and profitable only with a sufficiently high price. We derive the subgame perfect equilibrium for this game and investigate the price and investment dynamics through an experiment with human subjects. The experimental results show that service providers invest when decision-makers' interests align with their own, though prices may rise inefficiently high when the regulatory framework is made independent of future political manipulation. Independency of regulation thus decreases efficiency and consumer surplus. In contrast, when decision-makers' interests do not align with service providers' we find efficiency only when regulation can be made independent from electoral dynamics.