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Optimal State-Contingent Regulation Under Limited Liability

Author

Listed:
  • Robert Gary-Bobo

    (Universite' Paris 1)

  • Yossi Spiegel

    (Tel Aviv University)

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, which 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-type, two-state 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.

Suggested Citation

  • Robert Gary-Bobo & Yossi Spiegel, 2006. "Optimal State-Contingent Regulation Under Limited Liability," RAND Journal of Economics, The RAND Corporation, vol. 37(2), pages 431-448, Summer.
    • Handle: RePEc:rje:randje:v:37:y:2006:2:p:431-448
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    Citations

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    Cited by:

    1. Chillemi, Ottorino & Galavotti, Stefano & Gui, Benedetto, 2020. "Optimal contracts with contingent allocation," Economics Letters, Elsevier, vol. 192(C).
    2. Brown, David P. & Sappington, David E.M., 2020. "Motivating the optimal procurement and deployment of electric storage as a transmission asset," Energy Policy, Elsevier, vol. 138(C).
    3. Daniel Danau & Annalisa Vinella, 2017. "Contractual design in agency problems with non-monotonic cost and correlated information," SERIES 02-2017, Dipartimento di Economia e Finanza - Università degli Studi di Bari "Aldo Moro", revised Mar 2017.
    4. Leon Yang Chu & David E. M. Sappington, 2010. "Contracting with private knowledge of signal quality," RAND Journal of Economics, RAND Corporation, vol. 41(2), pages 244-269, June.
    5. Marina Halac & Pierre Yared, 2022. "Instrument-Based versus Target-Based Rules," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 89(1), pages 312-345.
    6. Danau, Daniel & Vinella, Annalisa, 2010. "Multi-agent contracting with countervailing incentives and limited liability," SIRE Discussion Papers 2010-13, Scottish Institute for Research in Economics (SIRE).
    7. Daniel Danau & Annalisa Vinella, 2020. "A note on optimal contracting with public ex post information under limited liability," International Journal of Game Theory, Springer;Game Theory Society, vol. 49(1), pages 47-74, March.
    8. Sandrine Ollier, 2007. "On the generalized principal-agent problem: a comment," Review of Economic Design, Springer;Society for Economic Design, vol. 11(1), pages 1-11, June.
    9. Daniel Danau & Analisa Vinella, 2016. "On the optimal use of correlated information in contractual design under limited liability," Economics Working Paper Archive (University of Rennes & University of Caen) 2016-05, Center for Research in Economics and Management (CREM), University of Rennes, University of Caen and CNRS.
    10. Sandrine Ollier, 2007. "On the generalized principal-agent problem: a comment," Post-Print hal-00447191, HAL.
    11. Armstrong, Mark & Sappington, David E.M., 2007. "Recent Developments in the Theory of Regulation," Handbook of Industrial Organization, in: Mark Armstrong & Robert Porter (ed.), Handbook of Industrial Organization, edition 1, volume 3, chapter 27, pages 1557-1700, Elsevier.

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