We apply the idea of relational contracting to a simple problem of regulating a single-product monopoly with unverifiable (then ex ante not contractible) quality. We model the interaction between the regulator and the firm as an infinitely repeated game; we observe that there exist self-enforcing contracts in which the regulator, using her discretionary power on the price (the contractible variable) can induce the firm to produce the required quality level by leaving it a positive rent. When players use grim trigger strategies, the 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 effect of the price on the deviation profits. Whenever the equilibrium profits of the static game are strictly positive, even if the firm were infinitely patient, the optimal contract would not reach the second-best: it would ensure a quality-adjusted Ramsey condition and, at the same time, leave positive profits to the firm. We extend the model in a few ways: we find that when players use stick-and-carrot strategies, with an infinitely patient firm the second-best outcome is reached even if this implies to punish the deviating firm with negative profits. When instead the regulator is unable to perfectly monitor the firm’s quality choice, the price/quality pair giving the highest payoff to the regulator does not directly depend on the firm’s discount factor, which instead affects the probability of punishment. Our results suggest that, in fixed price regulatory contracts, the regulatory lag should be shorter the more relevant is the issue of unverifiability, in order to reduce the reward for opportunistic behavior by the firm.

Cesi, B., Iozzi, A., Valentini, E. (2012). Regulating unverifiable quality by fixed-price contracts. THE B.E. JOURNAL OF ECONOMIC ANALYSIS & POLICY, 12(1) [10.1515/1935-1682.3083].

Regulating unverifiable quality by fixed-price contracts

CESI, BERARDINO;IOZZI, ALBERTO;
2012-01-01

Abstract

We apply the idea of relational contracting to a simple problem of regulating a single-product monopoly with unverifiable (then ex ante not contractible) quality. We model the interaction between the regulator and the firm as an infinitely repeated game; we observe that there exist self-enforcing contracts in which the regulator, using her discretionary power on the price (the contractible variable) can induce the firm to produce the required quality level by leaving it a positive rent. When players use grim trigger strategies, the 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 effect of the price on the deviation profits. Whenever the equilibrium profits of the static game are strictly positive, even if the firm were infinitely patient, the optimal contract would not reach the second-best: it would ensure a quality-adjusted Ramsey condition and, at the same time, leave positive profits to the firm. We extend the model in a few ways: we find that when players use stick-and-carrot strategies, with an infinitely patient firm the second-best outcome is reached even if this implies to punish the deviating firm with negative profits. When instead the regulator is unable to perfectly monitor the firm’s quality choice, the price/quality pair giving the highest payoff to the regulator does not directly depend on the firm’s discount factor, which instead affects the probability of punishment. Our results suggest that, in fixed price regulatory contracts, the regulatory lag should be shorter the more relevant is the issue of unverifiability, in order to reduce the reward for opportunistic behavior by the firm.
2012
Pubblicato
Rilevanza internazionale
Articolo
Esperti anonimi
Settore SECS-P/01 - ECONOMIA POLITICA
Settore SECS-P/02 - POLITICA ECONOMICA
Settore SECS-P/03 - SCIENZA DELLE FINANZE
Settore SECS-P/06 - ECONOMIA APPLICATA
English
Con Impact Factor ISI
quality regulation; relational contracts
Cesi, B., Iozzi, A., Valentini, E. (2012). Regulating unverifiable quality by fixed-price contracts. THE B.E. JOURNAL OF ECONOMIC ANALYSIS & POLICY, 12(1) [10.1515/1935-1682.3083].
Cesi, B; Iozzi, A; Valentini, E
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Utilizza questo identificativo per citare o creare un link a questo documento: https://hdl.handle.net/2108/71027
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