stopping agents from cheating abstract when a principal hires two or more agents to work in a correlated environment each agent s reward will depend on the other s performance unfortunately with just the usual optimal incentive constrained contracts being offered the agents strictly prefer to play equilibrium strategies other than those desired by the principal they cheat however the principal can use a more subtle contractual mechanism to stop them from cheating at no extra cost this mechanism uses one agent to police the other and exploits certain properties of the optimal contracts

defence procurement theory and uk policy since the early 1980s competition as a means of obtaining best value for money has dominated uk defence procurement policy this paper describes the uk defense equipment market and the procurement problem there are sections on the economic theory of procurement contracting regulation and competition the conclusion evaluates uk defence procurement policy and assesses some of the policy issues for the 1990s copyright 1996 by oxford university press

not only what but also when a theory of dynamic voluntary disclosure we examine a dynamic model of voluntary disclosure of multiple pieces of private information in our model a manager of a firm who may learn multiple signals over time interacts with a competitive capital market and maximizes payoffs that increase in both period prices we show perhaps surprisingly that in equilibrium later disclosures are interpreted more favorably even though the time the manager obtains the signals is independent of the value of the firm we also provide sufficient conditions for the equilibrium to be in threshold strategies

endogenous information flows and the clustering of announcements we consider the strategic timing of information releases in a dynamic disclosure model because investors don t know whether or when the firm is informed the firm will not necessarily disclose immediately we show that bad market news can trigger the immediate release of information by firms conversely good market news slows the release of information by firms thus our model generates clustering of negative announcements surprisingly this result holds only when firms can preemptively disclose their own information prior to the arrival of external information these results have implications for conditional variance and skewness of stock returns jel d21 d83 g12 g14 l11

product market competition and managerial slack this article analyzes the effect of product market competition on managerial incentives in contrast to hart 1983a i show that competition may actually exacerbate the incentive problem the difference in results derives from our different assumptions about managerial preferences the importance of assumptions about preferences suggests that we do not yet understand the precise mechanism through which competition affects incentives

second sourcing and the experience curve price competition in defense procurement we examine a dynamic model ofprice competition in defense procurement that incorporates the experience curve asymmetric cost information and the availability of a higher cost alternative system we model acquisition as a two stage process in which initial production is governed by a contract between the government and the developer competition is then introduced by an auction in which a second source bids against the developer for remaining production we characterize the class of production contracts that are cost minimizing for the government and that induce the developer to reveal private cost information when high costs are revealed these contracts result in a credible cutoff of new system production in favor of the still higher cost alternative system

multidimensional incentive compatibility and mechanism design abstract incentive compatibility conditions are characterized in general for problems in which several goods are to be allocated and agents types are multidimensional two questions of monopoly pricing under multidimensional uncertainty are then analyzed first we find the optimal nonlinear pricing scheme when the monopolist knows only the distribution of an arbitrarily parameterized family of demand curves and second we solve for the optimal bundling policy for a multiproduct monopolist

price caps and output floors a comparison of simple regulatory rules we study in this paper a simple alternative to price cap regulation the mechanism which we label output floor regulation requires the regulated firm to supply a given level of output this rule is as simple as price cap regulation and performs identically when the regulated firm is a natural monopoly however we show that in the presence of a competitive fringe output floor regulation yields lower prices and stronger incentives for cost reduction its introduction however is likely to be resisted by the industry since it lowers managerial utility and shareholders profits

incentive schemes with multiple agents and bankruptcy constraints abstract we explore the effects of bankruptcy constraints on incentive schemes when two risk neutral agents operate in correlated environments our focus is on the subgame equilibrium in which each agent is induced via a direct mechanism to truthfully reveal his private information as a nash response to truth telling by his counterpart we identify a class of examples in which in contrast to the case where the agents are risk averse the nash constraints induce a subgame dominant strategy equilibrium thus implementation via direct mechanisms is feasible for this class more generally however the truth telling nash equilibrium may be subgame dominated so the question of implementation via direct mechanisms remains a delicate one

essential facility financing and market structure abstract the paper analyzes the funding of an infrastructure project when an incumbent operator has private information about market profitability and the regulator does not have access to taxpayers money an open access policy raises welfare but may make the project non viable since funding must be provided by operators capital contributions we characterize the optimal market structure the regulator can ask the incumbent to bear a higher share of investment cost if the latter insists on an exclusive use yet the incumbent is willing to pay more for exclusivity the higher the demand that is precisely when competition yields the highest benefits at the optimum the incumbent s information is not used to determine market structure we further investigate the implications of this basic result in a dynamic context we show that the monopoly franchise policy is time consistent while an open access policy is not we also demonstrate that a threat of regulatory capture creates an open access presumption last we show that when the decision involves multiple projects monopoly segments should cross subsidize open access ones

government intervention in production and incentives theory a review of recent contributions national science foundation the commissariat general du plan and the center for energy policy research at m i t

managerial incentive problems a dynamic perspective the paper studies how a person s concern for a future career may influence his or her incentives to put in effort or make decisions on the job in the model the person s productive abilities are revealed over time through observations of performance there are no explicit output contingent contracts but since the wage in each period is based on expected output and expected output depends on assessed ability an implicit contract links today s performance to future wages an incentive problem arises from the person s ability and desire to influence the learning process and therefore the wage process by taking unobserved actions that affect today s performance the fundamental incongruity in preferences is between the individual s concern for human capital returns and the firm s concern for financial returns the two need be only weakly related it is shown that career motives can be beneficial as well as detrimental depending on how well the two kinds of capital returns are aligned it is well understood by now that informational externalities may place special demands on the organization of economic exchange simple price mediated markets will frequently fail in the presence of asymmetric information in that case more elaborate contractual arrangements have to be used as substitutes for the price system lately considerable effort has been devoted to the analysis of contracting under incomplete information with the objective to understand the range of economic institutions that emerge in response to the failure of the price system the analysis of moral hazard has played a prominent role in this development moral hazard problems arise when for some reason or another transacting parties cannot contract contingent on the delivery of the good for instance in buying labour services it may be that the amount of labour supplied is not directly observable precluding a simple exchange of wage for labour as a partial remedy to this problem an imperfect mutually observed signal about the supply of labour can be used as a proxy in the contract frequently output is taken as such a proxy the drawback is that output is often influenced by other factors than labour input which induce undesirable risk into the contract one is therefore faced with a tradeoff between allocating risk associated with incomplete observability and providing incentives for a proper supply of labour gaining insight into this tradeoff is important not only for understanding contracting in the small e g managerial incentive schemes but also because it is closely related to the fundamental tension between equity and efficiency in the society as a whole while our understanding of moral hazard has advanced a lot in past years it is clear that much work remains an important question that has received little attention until

strategic information revelation we analyze the problem in which agents have non public information and are to play an asymmetric information game the agents may reveal some or all of their information to other agents prior to playing this game revelation is via exogenously specified certifiable statements the equilibria resulting from various revelation strategies are used to determine equilibrium revelation of information sufficient conditions are provided for complete revelation of all private information a number of examples are provided illustrating when revelation will or will not occur in commonly analyzed games many economic problems are characterized by the presence of both strategic behaviour on the part of individuals and by asymmetric information models encompassing both of these characteristics have been used successfully to examine questions in many fields usually using the concept of bayesian nash equilibrium as the solution concept typically the agents information is given exogenously and is fixed throughout the analysis modelling the information structure as static is appropriate for some problems but not for all in particular situations that are inherently dynamic most economic encounters allow for some interchange between the agents before the outcome is settled irrevocably in such circumstances it is possible that at least one or more of the agents possessing non public information may be able to reveal part or all of his information to one or all of the other agents in the economy during the course of their contact to the extent that such a communication is believed by the other agents the priors of the other agents will change and we will have what is in essence a new asymmetric information game new in

monopoly with incomplete information recent theoretical research on principal agent relationships has emphasized incentive problems that arise when the parties involved are constrained by either asymmetric information or their inability to monitor each other s actions here we concentrate on the former constraint and consider the case of a single principal the monopolist the main contribution is to show that under a separability assumption strong conclusions can be drawn about the nature of optimal incentive schemes although the primary focus is on optimal quantity discounts in a monopolized market the results also shed light on related topics such as optimal income taxation and commodity bundling

pricing and entry in regulated industries the role of regulatory design abstract this paper studies the optimal regulatory policy in a market where entry may occur in the event of entry the regulator regulates the incumbent but not the entrant we show that the effect of entry on prices depends on the length of the interval between regulatory reviews if the gap is long then the market outcome following entry has a higher price than it would have with a shorter gap 1997 elsevier science s a

regulating an oligopoly with unknown costs abstract we examine the problem of a planner who is regulating an oligopoly with unknown costs we provide a complete characterization of the optimal mechanism which takes the following simple form firm s which report low costs produce together the first best output corresponding to this low cost and firm s which report high costs produce nothing when all firms report high costs only the ex ante least efficient firm produces the entire output and all the other firms produce nothing we show that under mild conditions as the number of firms increases the planner attains the same welfare level as if he had complete information of low cost

a real effects perspective to accounting measurement and disclosure implications and insights for future research accounting measurement and disclosure rules have a significant impact on the real decisions that firms make in this essay we provide an analytical framework to illustrate how such real effects arise using this framework we examine three specific measurement issues that remain controversial 1 how does the measurement of investments affect a firm s investment efficiency 2 how does the measurement and disclosure of a firm s derivative transactions affect a firm s choice of intrinsic risk exposures risk management strategy and the incentive to speculate 3 how could marking to market the asset portfolios of financial institutions generate procyclical real effects we draw upon these real effects studies to generate sharper and novel insights that we believe are useful not only for the development of accounting standards but also for guiding future empirical research

regulating a dominant firm unknown demand and industry structure in this article we study the optimal regulation of a dominant firm when an unregulated firm actively competes generally the existence of an active rival imposes new and binding constraints on regulatory problems we characterize optimal policies both when demands are known complete information and unknown incomplete information to the regulator optimal policies under complete information may set the price at the dominant firm above or below its marginal cost optimal policies under incomplete information may be either pooling or separating constant over a range of the prior distribution of the firm s private information and leave no information rent to the firm

lifetime consumption and investment retirement and constrained borrowing retirement flexibility and inability to borrow against future labor income can significantly affect optimal consumption and investment with voluntary retirement there exists an optimal wealth to wage ratio threshold for retirement and human capital correlates negatively with the stock market even when wages have zero or slightly positive market risk exposure consequently investors optimally invest more in the stock market than without retirement flexibility both consumption and portfolio choice jump at the endogenous retirement date the inability to borrow limits hedging and reduces the value of labor income the wealth to wage ratio threshold for retirement and the stock investment

procurement and renegotiation parties bound by an incomplete contract have an incentive to renegotiate after acquiring new information the issue of the parties investment in the relationship before renegotiation is analyzed in a simple two period procurement model the firm invests in the first period it then learns its production cost and the sponsor learns its value for the project williamson s underinvestment presumption is shown to hold under very general assumptions about bargaining and about the ex post asymmetry of information as long as the firm s investment is not observable by the sponsor the introduction of a cancellation fee may well lead to even less investment contrary to what is sometimes argued the role of ex ante price fixing as an alternative way to reintroduce some form of commitment and the problem of cost overruns are discussed last it is shown that if investment is observable by the sponsor andthus may become a joint decision variable the two parties may choose to under or overinvest

saving and investing for early retirement a theoretical analysis we study optimal consumption and portfolio choice in a framework where investors adjust their labor supply through an irreversible choice of their retirement time we show that investing for early retirement tends to increase savings and reduce an agent s effective relative risk aversion thus increasing her stock market exposure contrary to common intuition an investor might find it optimal to increase the proportion of financial wealth held in stocks as she ages and accumulates assets even when her income and the investment opportunity set are constant the model predicts a decrease in risk aversion following strong market gains like those observed in the nineties

disclosure and choice an agent chooses among projects with random outcomes his payoff is increasing in the outcome and in an observer s expectation of the outcome with some probability the agent will be able to disclose some information about the true outcome to the observer we show that choice is inefficient in general we illustrate this point with a characterization of the inefficiencies that result when the agent can perfectly disclose the outcome with some probability and can disclose nothing otherwise as in dye 1985a in this case the agent favours riskier projects even with lower expected returns on the other hand if information can also be disclosed by a challenger who prefers lower beliefs of the observer the chosen project is excessively risky when the agent has better access to information excessively risk averse when the challenger has better access and efficient otherwise we also characterize the agent s worst case equilibrium payoff we give examples of alternative disclosure technologies illustrating other forms the inefficiencies can take for example in a two dimensional setting we demonstrate a hitting for the fences effect where the agent systematically focuses on the harder dimension at the expense of success on the easier

informational feedback adverse selection and optimal disclosure policy faceless trading in a secondary stock market not only redistributes wealth among investors but also generates information that feeds back to real decisions using this observation we re evaluate the leveling the playing field rationale for disclosure to secondary stock markets by partially preempting traders information advantage established from information acquisition disclosure reduces private incentives to acquire information resulting in two opposite effects on firm value on one hand this narrows the information gap between informed and uninformed traders and improves liquidity of firm shares on the other hand this reduces the informational feedback from the stock market to real decisions this tradeoff determines the optimal disclosure policy the model explains why firm value can be higher in an environment that simultaneously promotes disclosure and private information production and why growth firms are endogenously more opaque than value firms

a theory of yardstick competition in the typical regulatory scheme a franchised monopoly has little incentive to reduce costs this article proposes a mechanism in which the price the regulatedfirm receives depends on the costs of identical firms in equilibrium each firm chooses a socially efficient level of cost reduction the mechanism generalizes to cover heterogeneous firms with observable differences medicare s prospective reimbursement of hospitals by using diagnostically related groups is a scheme very similar to the one outlined here

manipulated news model electoral competition and mass media abstract this paper investigates the relationship between media manipulation the strategic suppression of relevant information by mass media and self mediatization the strategic exploitation of media coverage by candidates in elections in the model a voter cannot directly observe the policies proposed by two office motivated candidates the voter learns this information through media reports before voting takes place while the media outlet suppresses some of this information because the voter s decision making could be incorrect direct distortion the candidates have an incentive to win the election by influencing the media coverage through policy settings indirect distortion as a result policy convergence to the voter s ideal policy occurs if and only if the media bias is sufficiently small we then characterize the set of equilibria in terms of the degree of distortion the results suggest that if either strategic media manipulation or competition among the candidates is omitted then the distortion is nonnegligibly misspecified

regulation asymmetric information and auditing this article analyzes a model of a regulated firm that is better informed about its cost function than is the regulator by auditing at a cost however the regulator is assumed to be able to observe the realized cost of the firm if the regulator finds that the firm had misrepresented its costs at the time at which prices were set he can order a refund to consumers in the optimal policy the regulator audits when the firm reports for pricing purposes that its costs will be high and orders a refund when the auditfinds that realized costs are lower than anticipated given the original report a separation result that obtains for an important case indicates that the initial pricing decision is independent of the auditing decision the auditing decision however depends on the price that was initially set the optimal auditing strategy is characterized and the nature of the welfare gains are identified the methodology used in the analysis involves the characterization of an equilibrium of a revelation game with an ex post observable

using cost observation to regulate firms the paper emphasizes the use of accounting data in regulatory or procurement contracts when the supplier 1 has superior information about the cost of the project and 2 invests in cost reduction the main result states that under risk neutrality the supplier announces an expected cost and is given an incentive contract linear in cost overruns this optimal contract moves toward a fixed price contract as the announced cost decreases an investment choice is then introduced and the use of a rate of return regulation is studied

annuities and individual welfare advancing annuity demand theory we present suffcient conditions for the optimality of full annuitization under market completeness that are substantially less restrictive than those used by yaari 1965 we examine demand with market incompleteness finding that positive annuitization remains optimal widely but complete annuitization does not how uninsured medical expenses affect demand for illiquid annuities depends critically on the timing of the risk a new set of calculations with optimal consumption trajectories very different from available annuity income streams still shows a preference for considerable annuitization suggesting that limited annuity purchases are plausibly due to psychological or behavioral biases

multi firm regulation without lump sum taxes abstract this paper considers a problem of multi firm regulation where the regulator cannot make monetary transfers to or from firms otherwise the set up is standard two firms charging two part tariffs sell in separate markets and marginal costs are private information without transfers the regulator faces an additional consumer participation constraint that the representative consumer must wish to participate in the market in all states the paper studies the second best optimal regulatory scheme that respects this constraint and shows that it has some surprising properties i the regulator may wish to drive informational rents down to zero even at the cost of some price distortion ii consumer surplus may be zero in some states and iii the price that one firm charges is decreasing in the other s cost

the optimal amount of discretion to allow in disclosure in this paper a party with private information can verifiably disclose some but not all of his information the optimal amount of discretion to allow the informed party is studied that is should the informed party be allowed unlimited discretion in choosing which elements of his information set to disclose or should restrictions be imposed that limit this discretion the model is formulated in the spirit of a persuasion game it is demonstrated that under certain circumstances rules that limit discretion increase the informativeness of disclosures and thus improve economic decisions

a complete solution to a class of principal agent problems with an application to the control of a self managed firm this paper considers a class of principal agent problems which have the following features 1 there is adverse selection because the principal ignores the value of one parameter of the agent s true characteristics 2 leaving aside the information parameter the principal s welfare as well as the agent s welfare depend on two types of variables observable to both of them the first ones possibly multidimensional are called action variable s and the second one which is one dimensional has in general the meaning of a money transfer 3 the principal is a stackelberg leader of the two person game he can commit himself to decision rules which are admissible on informational grounds he optimizes within the adequate class taking into account besides the agent s reaction one constraint which has generally the meaning of an individual rationality constraint and sometimes of a feasibility constraint the optimization is limited to the class of non stochastic mechanisms 4 the problem can also receive an alternative interpretation the principal faces a continuum of agents of unknown characteristics the distribution being known however stylized principal agent problems of this type have often been considered in the economic literature in particular the reader will later be able to recognize that the standard income tax model a la mirrlees 1971 the quality or quantity choice model of the monopolist a la mussa and rosen 1978 or maskin and riley 1982 and the model of government regulation of the private monopolist of baron and myerson 1982 all belong to

regulation competition and asymmetric information abstract this article studies a model of regulation under asymmetric information when there exists a competitive fringe of unregulated alternative producers the correlation between the unknown cost parameters of the fringe and of the regulated firm allows the regulator to use the threat of entry by the fringe to reduce the informational cost of regulation the presence of the fringe is welfare enhancing the allocative distortions can be larger or smaller than those in the no fringe case and the optimal contract sometimes allows inefficient entry the optimal contract can exhibit non standard bunching phenomena and discontinuities

optimal bypass and cream skimming this paper develops a normative model of regulatory policy toward bypass and cream skimming it analyzes the effects of bypass on second degree price discrimination on the rent of the regulated firm and on the welfare of low demand customers it shows that pricing under marginal cost may be optimal for the regulated firm excessive cream skimming occurs if access to the bypass technology is not regulated and the prohibition of bypass may increase or decrease the regulated firm s rent jel 026 613 the regulation of natural monopolies is often associated with policies toward competition including restrictions on entry this paper is concerned with a common form of competition which threatens the regulated firm on its most lucrative markets examples abound in the telecommunications industry the development of microwave radio and communication satellites in the 1960 s introduced the possibility that big telecommunication customers might bypass the major common carrier att and the 1978 natural gas policy act in the united states has created the possibility for industrial plants to bypass the local distribution utilities by building direct connections to the pipelines gas producers or intermediaries

optimal incentive contracts with multiple agents abstract a setting in which a single principal contracts with two agents who possess perfect private information about their own productivity is considered with correlated productivities each agent s private information also provides a signal about the other agent s productivity in contrast to the setting in which there is only one agent it is shown that such private information may be of no value to the agents it is only if the agents are risk averse that their private information may allow them to command rents moreover when the agents are constrained only to reveal their private information truthfully as a nash equilibrium the pareto optimal incentive scheme may induce the agents to adopt strategies other than truth telling this leads to the consideration of truth telling equilibria that are not pareto dominated in the subgame played by the agents among all such equilibria the one preferred by the principal restricts one agent to tell the truth as a dominant strategy and the other as a nash response to truth

the burden of proof in a game of persuasion abstract an arbitrator faces the task of deciding the level of compensation to be received by a plaintiff from a defendant the arbitrator must rely on the verifiable submissions of the two interested parties because the information of the interested parties is not verifiable the unravelling argument has no force nevertheless a class of equilibria of this game gives rise to a particularly simple decision rule for the arbitrator which appeals to a probability distribution over the payoff relevant state space alone the uncertainty concerning the precision of the disputants information enter as parameters in this distribution this parametrization yields an answer to how the arbitrator s decision rule should be modified as the information of the disputants changes journal of economic literature classification numbers d78 d82 l51

should intangibles be measured what are the economic trade offs we investigate whether a firm s intangible investments should be measured and separated from operating expenses we find that the information extracted from accounting reports of investments and earnings is different when intangibles are measured and identified separately from operating expenses than when intangibles are left commingled with operating expenses this difference in the market s information causes a change in the behavior of market prices inducing changes in the firm s investments and cash flows thus from a real effects perspective measuring intangibles is not unambiguously desirable we identify the conditions under which providing information on intangibles may be desirable this study also shows the inadequacy of statistical associations between accounting numbers and prices as a basis for evaluating the desirability of measuring intangible investments we show that the measurement of intangibles alters the very distribution of cash flows about which the measurement regime is seeking to provide information

powering up developing countries through integration power market integration is analyzed in a two country model with nationally regulated firms and costly public funds if the generation costs between the two countries are too similar negative business stealing outweighs efficiency gains so that the subsequent integration welfare decreases in both regions integration is welfare enhancing when the cost difference between two regions is large enough the benefits from export profits increase the total welfare in the exporting country whereas the importing country benefits from lower prices in this case market integration also improves incentives to invest compared to autarky the investment levels remain inefficient however especially for transportation facilities free riding reduces incentives to invest in these public good components of the network whereas business stealing tends to decrease the capacity to finance new investment

the cost of annuities implications for saving behavior and bequests the fact that most elderly u s individuals maintain a flat age wealth profile rather than buy individual life annuities contradicts the standard life cycle consumption model average expected yields on individual life annuities in the united states during 1968 1983 were lower by 4 21 6 13 percent or 2 43 4 35 percent after allowing for adverse selection than yields on plausible alternative investments simulations of a model of saving and portfolio allocation show that during the early retirement years such yield differentials can account for the absence of annuity purchases even without a bequest motive at older ages the combination of such yield differentials and a bequest motive can do so it is common experience that as we grow older and nearer to eternity we become more not less anxious about money derek brewer chaucer and his world p 213

optimal retirement with unemployment risks abstract this paper investigates the optimal retirement of an individual in the presence of involuntary unemployment risks and borrowing constraints in a complete market with frictions we use an intensity model and loading factors to illustrate the involuntary unemployment risks and frictions in unemployment insurance markets using reasonably calibrated parameters we observe that high involuntary unemployment intensity and loading factors could be important explanations for the empirical findings emphasized in recent studies we also find that an individual with high leisure demand after retirement reduces consumption during retirement and increases stockholdings as retirement time approaches

disclosures and asset returns public information in financial markets often arrives through the disclosures of interested parties who have a material interest in the reactions of the market to the new information when the strategic interaction between the sender and the receiver is formalized as a disclosure game with verifiable reports equilibrium prices can be given a simple characterization in terms of the concatenation of binomial pricing trees there are a number of empirical implications the theory predicts that the return variance following a poor disclosed outcome is higher than it would have been if the disclosed outcome were good also when investors are risk averse this leads to negative serial correlation of asset returns other points of contact with the empirical literature are discussed

a generalization of yaari s result on annuitization with optimal retirement abstract in this paper we generalize the following result of yaari 1965 on annuitization with an agent s optimal retirement it is optimal for individuals to annuitize all of their wealth in the absence of bequest motive we have other results that refine or extend the result of yaari 1965 full annuitization can be viewed as an american type option that allows an economic agent to exchange the value of labor income with the extra leisure that is brought about by annuitizing all of her wealth when the agent s wealth is above a certain wealth threshold annuitization is triggered otherwise it is not accordingly wealth plays a key role in controlling the distance to full annuitization

regulating a monopolist with unknown costs we consider the problem of how to regulate a monopolistic firm whose costs are unknown to the regulator the regulator s objective is to maximize a linear social welfare function of the consumers surplus and the firm s profit in the optimal regulatory policy prices and subsidies are designed as functions of the firm s cost report so that expected social welfare is maximized subject to the constraints that the firm has nonnegative profit and has no incentive to misrepresent its costs we explicitly derive the optimal policy and analyze its properties in their classic papers dupuit 2 and hotelling 5 considered pricing policies for a bridge that had a fixed cost of construction and zero marginal cost they demonstrated that the pricing policy that maximizes consumer well being is to set price equal to marginal cost and to provide a subsidy to the supplier equal to the fixed cost so that a firm would be willing to provide the bridge this first best solution is based on a number of informational assumptions first the demand function is assumed to be known to both the regulator and to the firm while the assumption of complete information may be too strong the assumption that information about demand is as available to the regulator as it is to the firm does not seem unnatural a second informational assumption is that the regulator has complete information about the cost of the firm or at least has the same information about cost as does the firm this assumption is unlikely to be met in reality since the firm would be expected to have better information about costs than would the regulator as weitzman has stated an essential feature of the regulatory environment i am trying to describe is uncertainty about the exact specification of each firm s cost function in most cases even the managers and engineers most closely associated with production will be unable to precisely specify beforehand the cheapest way to generate various hypothetical output levels because they are yet removed from the production process the regulators are likely to be vaguer still about a firm s cost function 12 p 684 as this observation suggests it is natural to expect that a firm would have better information regarding its costs than would a regulator the purpose of this paper is to develop an optimal regulatory policy for the case in which the regulator does not know the costs of the firm one strategy that a regulator could use in the absence of full information about costs is to give the firm the title to the total social surplus and to delegate the pricing decision to the firm in pursuing its own interests which would then be to maximize the total social surplus the firm would adopt the same marginal cost pricing strategy that the regulator would have imposed if the regulator had