Informational Asymmetry, Limits to Regulation, and Implications for Using Incentives Versus Command and Control

Core References

Privatization, Restructuring, and Regulation of Network Industries
Cambridge, MA: MIT Press, 1999, Chapter 2.
Newbery, David M.

Explains that the interaction between the regulator and the regulated firm can be modeled as a game in which the regulated firm has private information. The regulator chooses and announces the incentives that the regulator will provide the firm. Then the firm decides how it will operate. Next the regulator observes the operations and allows the firm the incentives promised. If the firm does not believe that the regulator will keep her commitment, the firm will not perform optimally.

Designing Incentive Regulation for the Telecommunications Industry
Cambridge, MA: MIT Press, 1996, Chapter 1.
Sappington, David E.M., and Dennis L. Weisman

Explains that incentive regulation is useful because the firm has (or can acquire) better information than the regulator about important aspects of the industry and the firm’s objectives and the consumers’ objectives are different. If the regulator had the same information that the firm has, then the regulator could simply micromanage the firm. If the firm had the same goals as consumers, then the firm would naturally do exactly what the regulator wanted the firm to do. In most situations, however, the firm has better information than the regulator and seeks to maximize its profits (whereas consumers seek to maximize their surplus), so incentive regulation can be used to improve the operator’s performance.

Privatization: An Economic Analysis
Cambridge, MA: MIT Press, 1988, Chapter 2.
Vickers, John, and George Yarrow

Explains that information asymmetry is at the heart of the economics of regulation. A fully informed regulator with complete authority could simply order the firm to choose the first-best outcome. However, regulators are never fully informed and have limited powers. “The problem for regulatory policy is one of incentive mechanism design – how to induce the firm to act in accordance with the public interest (which will depend on the state of technology and demand) without being able to observe the firm’s behavior.”

Key Words

Information, Information Asymmetry, Accountability, Forms of regulation, Price cap regulation, Rate-of-return regulation, Regulatory procedures, Commitment, Incentive Regulation