Regulatory Policy Design in an Uncertain World

The paper examines principal-agent relationships in uncertain environments where beliefs of the contracting parties (the regulator and the firm) are represented by sets of probabilities. In addition to fully characterizing the first-best and the second-best solutions, we examine optimality of zero-risk, fixed-payment schemes and the relationship between the first-best and the second-best solutions. In the second-best world, where the regulator can only contract on the quality of the good, a zero-risk standard is optimal when the firm has beliefs that are so ambiguous that the firm's marginal rate of transformation belongs to the set of the firm's relative probabilities. Copyright © 2010 Wiley Periodicals, Inc..