Regulation of Quality and the Ratchet Effect: Does Unverifiability Hurt the Regulator?

Dag Morten Dalen

Journal of Regulatory Economics, 1997, vol. 11, issue 2, 139-55

Abstract: The paper considers a regulatory relationship in which the quality of the output produced by the firm may be hard to verify. When the regulator's commitment power is unlimited, one finds that unverifiability always hurts the regulator. Here it is shown that this need no longer be the case if the regulator's commitment power is limited. If unverifiability makes the regulator offer low-powered incentive schemes, the firm's rent from having private information about the technology is reduced. In long-term relationships, such a reduction in the information rent mitigates the ratchet effect, and by means of numerical examples it is shown that this positive effect of unverifiability may dominate the standard static cost of unverifiability. Copyright 1997 by Kluwer Academic Publishers

Date: 1997
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