Regulating unverifiable quality by fixed-price contracts

We apply the idea of relation contracting to a very simple problem of regulating a single-product monopolistic firm when the regulatory instrument is a fixed-price contract, and quality is endogenous and observable, but not verifiable. We model the interaction between the regulator and the firm as a dynamic game, and we show that, provided both players are su±ciently patient, there exist self-enforcing regulatory contracts in which the firm prefers to produce the quality mandated by the regulator, while the regulator chooses to leave the firm a positive rent as a reward to its quality choice. We also show that the socially optimal self-enforcing contract implies a distortion from the second best, which is greater the more impatient is the firm and the larger is the (marginal) effect of the contractual price on the profits the firm would make by deviating from the offered contract. Whenever the punishment profits are strictly positive, even if the firm were infinitely patient, the optimal contract would ensure a Ramsey condition but with positive profits to the firm. Our result also illustrates that,whenever the firm's output has some unverifiable component, optimal regulatory lag in fixed-price contract should be reduced to limit the reward of the firm's opportunistic behaviour.