Chapter 24 Design of regulatory mechanisms and institutions

This chapter focuses on the design of regulatory policies that take into account the opportunities for strategic behavior provided by incomplete information and limited observability on the part of the regulator. The design of regulatory mechanisms is straightforward, albeit complex, in such a case where the regulator or mechanism designer has the same information as the regulated firm, observes the actions taken by the firm and has the authority to exercise control. The chapter presents the design of regulatory mechanisms and institutions in settings in which the regulator has incomplete information and limited ability to observe the actions of the firms under its jurisdiction. Incomplete information and limited observability create opportunities for strategic behavior on the part of both the regulator and the regulated. The mechanisms considered are reflections of that strategic behavior and are characterized as equilibria of a game whose structure corresponds to the authority granted to the regulator. Regulatory policies are, thus, viewed as endogenous responses to informational asymmetries and limited observability rather than as exogenously specified mechanisms descriptive of actual regulatory arrangements. Although the mechanisms are weak in their descriptive power, they reflect the incentives present in regulatory relationships and take into account the way the parties involved respond to those incentives.