Optimal Regulation with Costly Verification

35 Pages Posted: 12 Mar 2021 Last revised: 3 Aug 2022

See all articles by Petteri Palonen

Petteri Palonen

University of Helsinki - Helsinki Graduate School of Economics

Teemu Pekkarinen

Massachusetts Institute of Technology (MIT)

Date Written: August 3, 2022


We consider a principal-agent model in which the principal can monitor and punish the agent with a fine if the agent is caught being untruthful. To reduce the probability of being verified, the agent can engage in costly avoidance. We design the optimal regulatory policies with and without avoidance. The optimal mechanism with enforcement allocates the object more often than the optimal mechanism without enforcement. Moreover, enforcement increases the expected transfers to the principal. Avoidance has two implications to the optimal regulatory mechanism: (i) the expected optimal transfers to the principal decrease and (ii) the principal allocates the object to a smaller share of types. If the latter effect dominates the former, it is possible that the agent's capability to engage in avoidance is disadvantageous not only for the principal, but also for the agent ex ante.

Keywords: Mechanism Design, Verification, Enforcement, Monitoring, Avoidance, Fines.

JEL Classification: D82, D86, L51

Suggested Citation

Palonen, Petteri and Pekkarinen, Teemu, Optimal Regulation with Costly Verification (August 3, 2022). Available at SSRN: https://ssrn.com/abstract=3729347 or http://dx.doi.org/10.2139/ssrn.3729347

Petteri Palonen

University of Helsinki - Helsinki Graduate School of Economics ( email )

P.O. Box 17 (Arkadiankatu 7)
Helsinki, FI00014

Teemu Pekkarinen (Contact Author)

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

HOME PAGE: http://www.teemupekkarinen.com

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