Dynamic Regulation of Public Franchises with Imperfectly Correlated Demand Shocks

In a continuous-time setting, we study the design of a dynamic contract between a government and a private entity, wherein the latter commits to pay the government in return for the exclusive right to sell a service by operating a public facility. Private revenues are modelled as depending on the unobservable ability to seize market opportunities and on imperfectly correlated changes in consumers' preferences. We show that optimal regulation requires an appropriate combination of fixed and variable payments to the government, acting together both as an information revelation mechanism and as a risk sharing device.