Optimal Selection of a Regulated Monopoly
by
Peter S. Faynzilberg
MEDS, Northwestern University

In the context of regulating a monopolist with uncertain costs, the paper provides a complete characterization of the optimal contract in the principal-agent model with hidden information.

Both the output-subsidy allocations and the scope of participation, i.e., the set of monopolist's types that enter the regulated market, are treated endogenously. This is based on the more general methodology of Faynzilberg (1999); for details, see the presentation on “Participation Rights and Mechanism Design.”

Two characterizations of the optimal policy are provided. The first involves, in similarity with that of Holmström (1979) for agency with hidden actions, both the contract itself and the shadow costs of incentives. In contrast to the hidden-actions case, we are able to find the shadow costs in closed form and isolate them from the first-order conditions. This yields the second characterization that involves the optimal policy only.

The characterization-based solution procedure is made efficient by the presently formulated quantization condition that allows the regulator to make all pooling decisions simultaneously. This is in contrast to stage-wise procedures (e.g., Guesnerie and Laffont, 1984) and the convexification hierarchy of Baron and Myerson (1982) that reduces to a single quantization condition.

We find that, generically, the regulator has at his disposal a discrete spectrum of locally-optimal regulatory regimes. This spectrum may be rather large even in relatively simple settings, and the task of selecting from it the second-best contract is generally nontrivial. We illustrate the solution methodology on three policy spectra computed in closed form.

Date received: June 7, 2000

Copyright © 2000 by the author(s). The author(s) of this document and the organizers of the conference have granted their consent to include this abstract in Atlas Conferences Inc. Document # cafi-02.