How to Get Firms to Invest: A Simple Solution to the Hold-Up Problem in Regulation
15 Pages Posted: 5 Nov 1999
Date Written: September 1999
Many governmental programs are effective only if firms make costly investments. The inability of authorities to precommit to a regulatory scheme creates incentives for firms not to invest and to hold up the regulator. This paper describes a simple subsidy/tax scheme embedded in a four-stage mechanism that solves the hold-up problem. We design a self-financing subsidy/tax scheme which benefits a complying firm at the expense of a non-complying firm. In order to be credible, the subsidy and tax rates must maximize social welfare for any combination of investment decisions. We show that there exists a unique subgame perfect equilibrium in which all firms invest and no actual implementation with subsidies and taxes is required. We discuss in which cases the mechanism can work under incomplete information.
JEL Classification: L23, L51
Suggested Citation: Suggested Citation