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Optimal State-Contingent Regulation under Limited Liability

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Author Info
Gary-Bobo, Robert J.
Spiegel, Yossi

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

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Find related papers by JEL classification:
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation

References listed on IDEAS
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  1. Dominique M. Demougin & Devon A. Garvie, 1991. "Contractual Design with Correlated Information under Limited Liability," RAND Journal of Economics, The RAND Corporation, vol. 22(4), pages 477-489, Winter. [Downloadable!] (restricted)
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  2. Paul L. Joskow, 2001. "California's Electricity Crisis," NBER Working Papers 8442, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  3. Robert, Jacques, 1991. "Continuity in auction design," Journal of Economic Theory, Elsevier, vol. 55(1), pages 169-179, October. [Downloadable!] (restricted)
  4. 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. [Downloadable!] (restricted)
  5. 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. [Downloadable!] (restricted)
  6. Laffont, Jean-Jacques & Tirole, Jean, 1986. "Using Cost Observation to Regulate Firms," Journal of Political Economy, University of Chicago Press, vol. 94(3), pages 614-41, June. [Downloadable!] (restricted)
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  7. Laffont, Jean-Jacques & Maskin, Eric, 1980. "A Differential Approach to Dominant Strategy Mechanisms," Econometrica, Econometric Society, vol. 48(6), pages 1507-20, September. [Downloadable!] (restricted)
  8. Anke Kessler & Christoph Lülfesmann & Patrick Schmitz, 2000. "Optimal Contracting with Verifiable Ex Post Signals," Bonn Econ Discussion Papers bgse19_2000, University of Bonn, Germany. [Downloadable!]
  9. 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. [Downloadable!] (restricted)
  10. 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. [Downloadable!] (restricted)
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  11. 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. [Downloadable!] (restricted)
  12. David P. Baron & David Besanko, 1984. "Regulation, Asymmetric Information, and Auditing," RAND Journal of Economics, The RAND Corporation, vol. 15(4), pages 447-470, Winter. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Roland Strausz, 2005. "Interim Information in Long Term Contracts," Discussion Papers 40, SFB/TR 15 Governance and the Efficiency of Economic Systems, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich. [Downloadable!]
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  2. Sandrine Ollier, 2007. "On the generalized principal-agent problem: a comment," Review of Economic Design, Springer, vol. 11(1), pages 1-11, June. [Downloadable!] (restricted)
  3. Cécile Aubert & Jérôme Pouyet, 2006. "Incomplete regulation, market competition and collusion," Review of Economic Design, Springer, vol. 10(2), pages 113-142, August. [Downloadable!] (restricted)
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