Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/200152 
Year of Publication: 
2019
Series/Report no.: 
DICE Discussion Paper No. 318
Publisher: 
Heinrich Heine University Düsseldorf, Düsseldorf Institute for Competition Economics (DICE), Düsseldorf
Abstract: 
Regulators and the firms they regulate interact repeatedly. Over the course of these interactions, the regulator collects data that contains information about the firm's idiosyncratic private characteristics. This paper studies the case in which the regulator uses information gleaned from past cost observations when designing the current period's contract. Cost observations are obscured in stochastic settings and so perfect inferences about underlying private information are not possible. However, the design of the regulatory contract affects how much information is gleaned. When learning more about the firm's type, the regulator increases expected second period welfare by reducing distortions tied to asymmetric information. In contrast, by learning less about the firm's type, the regulator reduces incentive payments in first period. The trade-off between the desire to be more informed and to reduce incentive payments leads to a contracting dynamic that aligns with anecdotal, experimental and empirical evidence of the ratchet effect.
Subjects: 
Dynamic Contracts
Dynamic Agency
Ratchet Effect
Experimentation
Signal Dampening
Regulation
JEL: 
D8
C73
L5
ISBN: 
978-3-86304-317-9
Document Type: 
Working Paper

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