Abstract
We study the optimal regulation of a monopolist when intrinsic efficiency (intrinsic cost) and empire building tendency (marginal utility of output) are private information, but actual cost (the difference between intrinsic cost and effort level) is observable. This is a problem of multidimensional screening with complementary activities. Results are not only driven by the prior probabilities of the four possible types, but also by the relative magnitude of the uncertainty along the two dimensions of private information. If the marginal utility of output varies much more (less) across managers than the intrinsic marginal cost, there is empire building (efficiency) dominance. In that case, an inefficient empire builder produces more (less) and at lower (higher) marginal cost than an efficient money-seeker. It is only when variabilities are similar that there may be the natural ranking of activities (empire builders produce more, while efficient managers produce at a lower cost).
Highlights
Armstrong and Rochet [1] have provided a “user’s guide” for studying multidimensional screening problems.1 They studied a model with two activities, focusing on the case in which the utility functions of the agent and of the principal are additively separable in the levels of the two activities
Assuming that the variabilities of efficiency and the tendency for empire building are equal, we find three kinds of solutions: (i) output bunching between the money-seekers and marginal cost bunching between the inefficient managers; (ii) output bunching between the inefficient empire builder and the efficient money-seeker; and (iii) natural ranking of activities, i.e., more efficient types producing at lower marginal cost, types with a stronger tendency for empire building producing more output
When Case A is optimal in the relaxed problem, output and marginal cost levels are ranked in the natural way, with a bunching of the worst types in each activity: qEB > qIB ≥ qEM = qIM, cEB < cEM ≤ cIB = cIM
Summary
Armstrong and Rochet [1] have provided a “user’s guide” for studying multidimensional screening problems. They studied a model with two activities, focusing on the case in which the utility functions of the agent and of the principal are additively separable in the levels of the two activities (independent activities). We study the case in which the private information of the manager bears simultaneously on the value of the intrinsic marginal cost and on the value of the marginal utility of output This leads to a two-dimensional screening model with complementary activities. It is a substantive one: we aim at analyzing the characteristics of optimal contracts between regulator and manager in the two-dimensional case, where the manager’s preference for high output is private information, as well as his/her intrinsic efficiency It is a methodological one: we want to see how the method proposed by Armstrong and Rochet [1] performs in the case of complementary activities..
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