Working Paper: CEPR ID: DP3920
Authors: 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.
Keywords: Asymmetric Information; Correlated Information; Cost Shocks; Limited Liability; Optimal Regulation
JEL Codes: D82; L51
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| realization of cost shocks (E39) | firm's cost type (D21) |
| firm's cost type (D21) | design of regulatory scheme (G18) |
| realization of cost shocks (E39) | design of regulatory scheme (G18) |
| maximum loss a firm can sustain (G33) | first-best allocation (D61) |
| first-best allocation (D61) | production levels for inefficient types (E23) |
| observable shocks (D80) | regulatory outcomes (K20) |