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Optimal State-Contingent Regulation under Limited Liability

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  • Gary-Bobo, Robert J.
  • Spiegel, Yossi

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

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3920.

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Date of creation: Jun 2003
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Handle: RePEc:cpr:ceprdp:3920

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Keywords: asymmetric information; correlated information; cost shocks; limited liability; optimal regulation;

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  1. 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.
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  3. 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. Sandrine Ollier, 2007. "On the generalized principal-agent problem: a comment," Review of Economic Design, Springer, vol. 11(1), pages 1-11, June.
  2. Mikhail Drugov, 2011. "Intra-firm bargaining and learning in a market equilibrium," Economics Working Papers we1102, Universidad Carlos III, Departamento de Economía.
  3. Roland Strausz, 2006. "Interim Information in Long-Term Contracts," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 15(4), pages 1041-1067, December.
  4. Cécile Aubert & Jerôme Pouyet, 2004. "Incomplete Regulation, Market Competition and Collusion," Working Papers 2004-39, Centre de Recherche en Economie et Statistique.
  5. Mikhail Drugov, 2010. "Information and delay in an agency model," RAND Journal of Economics, RAND Corporation, vol. 41(3), pages 598-615.

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