Asymmetric information and economic incentives in optimal regulation

Abstract

During the 1970s and 1980s we witnessed a renewed interest in the regulation of natural monopolies and oligopolies. In the policy arena discontent was expressed with the price, quality, and cost performance of regulated firms. The remedies sought in specific industries differed remarkably: More powerful incentive schemes were proposed and implemented, deregulation was encouraged to free up competition and entry, and in some countries changing in ownership (privatization) occurred. Meanwhile the academic debate attempted to shed light on some shortcomings of the generally accepted theory of regulation such as rate-of-regulation. Regulatory theory largely ignored incentive issues. The limited access to information of regulators was the source of inefficient regulatory outcomes. Furthermore, the considerable simplified formal models that assumed away imperfect information were less realistic in that they implied policy recommendation that require information not available to regulators in practice. Many of the incentive schemes proposed recently have aimed to promote competition, to encourage economic efficiency and to streamline regulator``s workloads under asymmetric information. Although significant results have been obtained in the way of designing and justifying alternative approaches, there still remains an important class of economic problems that are difficult to solve by those approaches and that arise frequently in several applications: regulation of interdependent economic agents in the context of asymmetric information. The basic question is how to make an optimal incentive scheme which will induce firms to do what is best in the context of asymmetric regulatory information. How then can the regulator be sure that prices by the firms are maximizing the regulator``s objective? For the case in which the regulator knows some economic information such as demand or total cost, some regulatory incentive schemes solve this problem through a generous subsidy. ...