Regulating unverifiable quality by fixed-price contracts

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 su±ciently patient, there exist self-enforcing regulatory contracts in which the firm prefers to produce the quality mandated 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 ¯rm and the larger is the (marginal) e®ect of the contractual price on the pro¯ts the ¯rm would make by deviating from the o®ered contract. Whenever the punishment pro¯ts are strictly positive, even if the ¯rm were in- ¯nitely patient, the optimal contract would ensure a Ramsey condition but with positive pro¯ts to the ¯rm. 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.