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Regulating unverifiable quality by fixed-price contracts

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  • Cesi Berardino

    () (THEMA Université de Cergy-Pontoise and Roosevelt Academy (Utrecht University) Author-Name : Alberto Iozzi Author-Email : alberto.iozzi@uniroma2.it
    Università di Roma "Tor Vergata" Author-Name : Edilio Valentini Author-Email : valentin@unich.it
    Università "G. D'Annunzio"di Chieti-Pescar)

Abstract

We apply the idea of relation contracting to a very simple problem of regulating a single-product monopolistic firm when the regulatory instrument is a fixed-price contract, and quality is endogenous and observable, but not verifiable. We model the interaction between the regulator and the firm as a dynamic game, and we show that, provided both players are sufficiently patient, there exist self-enforcing regula- tory contracts in which the firm prefers to produce the quality man- dated by the regulator, while the regulator chooses to leave the firm a positive rent as a reward to its quality choice. We also show that the socially optimal self-enforcing contract implies a distortion from the second best, which is greater the more impatient is the firm and the larger is the (marginal) effect of the contractual price on the profits the firm would make by deviating from the offered contract. Whenever the punishment profits are strictly positive, even if the firm were infinitely patient, the optimal contract would ensure a Ramsey condition but with positive profits to the firm. Our result also illustrates that, whenever the firm's output has some unverifiable component, optimal regulatory lag in fixed-price contract should be reduced to limit the reward of the firm's opportunistic behaviour.

Suggested Citation

  • Cesi Berardino, 2009. "Regulating unverifiable quality by fixed-price contracts," THEMA Working Papers 2009-14, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
  • Handle: RePEc:ema:worpap:2009-14
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    References listed on IDEAS

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    Cited by:

    1. Albano, Gian Luigi & Cesi, Berardino & Iozzi, Alberto, 2017. "Public procurement with unverifiable quality: The case for discriminatory competitive procedures," Journal of Public Economics, Elsevier, vol. 145(C), pages 14-26.
    2. Gian Luigi Albano & Berardino Cesi & Alberto Iozzi, 2017. "Teaching an old dog a new trick: reserve price and unverifiable quality in repeated procurement," CEIS Research Paper 404, Tor Vergata University, CEIS, revised 05 May 2017.

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    More about this item

    Keywords

    Quality regulation; relational contracts;

    JEL classification:

    • L13 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Oligopoly and Other Imperfect Markets
    • L50 - Industrial Organization - - Regulation and Industrial Policy - - - General

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