Optimal State-Contingent Regulation Under Limited Liability

37 Pages Posted: 25 Jul 2003

See all articles by Robert J. Gary-Bobo

Robert J. Gary-Bobo

CREST ENSAE; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Yossi Spiegel

Tel Aviv University, Coller School of Management; Centre for Economic Policy Research (CEPR); ZEW – Leibniz Centre for European Economic Research

Date Written: June 2003

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 that 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-types, two-states 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.

Keywords: Optimal regulation, asymmetric information, cost shocks, limited liability, correlated information

JEL Classification: D82, L51

Suggested Citation

Gary-Bobo, Robert J. and Spiegel, Yossi, Optimal State-Contingent Regulation Under Limited Liability (June 2003). CEPR Discussion Paper No. 3920. Available at SSRN: https://ssrn.com/abstract=428089

Robert J. Gary-Bobo (Contact Author)

CREST ENSAE ( email )

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HOME PAGE: http://www.crest.fr/ses.php?user=3042

CESifo (Center for Economic Studies and Ifo Institute) ( email )

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Germany

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Yossi Spiegel

Tel Aviv University, Coller School of Management ( email )

Ramat Aviv, Tel Aviv, 69978
Israel
972-3-640-9063 (Phone)
972-3-640-7739 (Fax)

HOME PAGE: http://www.tau.ac.il/~spiegel

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

ZEW – Leibniz Centre for European Economic Research ( email )

P.O. Box 10 34 43
L 7,1
D-68034 Mannheim, 68034
Germany

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