A Model of Final Offer Arbitration in Regulation

I study a regulatory process in which both the regulator and the regulated firm propose prices that, in case of disagreement, are settled through final-offer arbitration (FOA)—a practice currently used in Chile for setting prices in the water sector. Rather than submitting a single offer, each party simultaneously submits an offer for each of the firm’s cost units (e.g., cost of raw water, capital cost). While a multiple-offers scheme allow the arbitrator to better approximate her ideal settlement, it may induce parties to submit widely divergent offers. This divergence, however, does not affect the arbitrator’s ability to learn from the offers.