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Optimal state‐contingent regulation under limited liability

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  • Robert Gary‐Bobo
  • Yossi Spiegel

Abstract

We consider an optimal regulation model in which the regulated firm’s production cost is subject to random, publicly observable shocks. The distribution of these shocks is correlated with the firm’s cost type, which is private information. The regulator designs an incentive compatible regulatory scheme that adjusts itself automatically ex-post given the realization of the cost shock. We derive the optimal scheme, assuming that there is an upper bound on the financial losses that the firm can sustain in any given state. We first consider a two-types, two-states case, and then extend the results to the case of a continuum of firm types and an arbitrary finite number of states. We show that the first best allocation can be implemented if the state of nature conveys enough information about the firm’s type and (or) the maximal loss that the firm can sustain is sufficiently large. Otherwise, the solution is characterized by classical second-best features.

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Bibliographic Info

Article provided by RAND Corporation in its journal RAND Journal of Economics.

Volume (Year): 37 (2006)
Issue (Month): 2 (06)
Pages: 431-448

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Handle: RePEc:bla:randje:v:37:y:2006:i:2:p:431-448

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References

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  1. Dominique M. Demougin & Devon a. Garvie, 1991. "Contractual Design with Correlated Information Under Limited Liability," Working Papers 815, Queen's University, Department of Economics.
  2. Steven R. Williams & Georgia Kosmopoulou, 1998. "The robustness of the independent private value model in Bayesian mechanism design," Economic Theory, Springer, vol. 12(2), pages 393-421.
  3. Riordan, Michael H. & Sappington, David E. M., 1988. "Optimal contracts with public ex post information," Journal of Economic Theory, Elsevier, vol. 45(1), pages 189-199, June.
  4. Cremer, Jacques & McLean, Richard P, 1985. "Optimal Selling Strategies under Uncertainty for a Discriminating Monopolist When Demands Are Interdependent," Econometrica, Econometric Society, vol. 53(2), pages 345-61, March.
  5. Paul R. Milgrom, 1981. "Good News and Bad News: Representation Theorems and Applications," Bell Journal of Economics, The RAND Corporation, vol. 12(2), pages 380-391, Autumn.
  6. Jean Tirole & Jean-Jaques Laffont, 1985. "Using Cost Observation to Regulate Firms," Working papers 368, Massachusetts Institute of Technology (MIT), Department of Economics.
  7. Cremer, Jacques & McLean, Richard P, 1988. "Full Extraction of the Surplus in Bayesian and Dominant Strategy Auctions," Econometrica, Econometric Society, vol. 56(6), pages 1247-57, November.
  8. Paul L. Joskow, 2001. "California's Electricity Crisis," Oxford Review of Economic Policy, Oxford University Press, vol. 17(3), pages 365-388.
  9. Robert, Jacques, 1991. "Continuity in auction design," Journal of Economic Theory, Elsevier, vol. 55(1), pages 169-179, October.
  10. Laffont, Jean-Jacques & Maskin, Eric, 1980. "A Differential Approach to Dominant Strategy Mechanisms," Econometrica, Econometric Society, vol. 48(6), pages 1507-20, September.
  11. Anke Kessler & Christoph Lülfesmann & Patrick Schmitz, 2000. "Optimal Contracting with Verifiable Ex Post Signals," Bonn Econ Discussion Papers bgse19_2000, University of Bonn, Germany.
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Cited by:
  1. Mikhail Drugov, 2011. "Intra-firm bargaining and learning in a market equilibrium," Economics Working Papers we1102, Universidad Carlos III, Departamento de Economía.
  2. Mikhail Drugov, 2010. "Information and delay in an agency model," RAND Journal of Economics, RAND Corporation, vol. 41(3), pages 598-615.
  3. Cécile Aubert & Jérôme Pouyet, 2006. "Incomplete regulation, market competition and collusion," Review of Economic Design, Springer, vol. 10(2), pages 113-142, August.
  4. Roland Strausz, 2006. "Interim Information in Long-Term Contracts," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 15(4), pages 1041-1067, December.
  5. Sandrine Ollier, 2007. "On the generalized principal-agent problem: a comment," Review of Economic Design, Springer, vol. 11(1), pages 1-11, June.

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