Regulating a monopolist with unknown bureaucratic tendencies

Abstract

We determine the optimal contract for the regulation of a bureaucratic firm in the case in which the bureaucratic bias is firm's private information. We find that output is distorted upward when the bureaucratic bias is low, downward when it is high, and equals a reference output when it is intermediate (in this case, the participation constraint is binding). We also determine an endogenous reference output (equal to the expected output, which depends on the reference output), and find that the response of output to cost is null in the short-run (in which the reference output is fixed) whenever the managers' types are in the intermediate range and negative in the long-run (after the adjustment of the reference output to equal expected output).Procurement, Regulation, Adverse selection, Bureaucracy, Reservation utility