Incomplete Contracting and Price Regulation
Dieter Bös · SSRN Electronic Journal · 2000
Consider a licensing contract where a monopolistic grid sells a license to a competitive licensee. Unless it is regulated, the grid will exploit its monopolistic position which, in turn, will imply an exploitation of the consumers who buy the end product from the licensee. Therefore, the government regulates the price at which the grid sells the license. The licensing contract is incomplete in the sense of Hart and Moore: it cannot be conditioned on the licensee's utility which is private information of the licensee and it cannot be conditioned on the relationship-specific investments of both grid and licensee. The paper develops a sequential regulatory mechanism which implements the first best. However, this may require upward renegotiation of the regulated price. Accordingly, price-cap regulation fails to achieve the first best since price caps forbid upward renegotiation.