Regulation and Moral Hazard

Moral hazard refers to a situation in which one party in a contractual relationship can unilaterally undertake actions that cannot be monitored and controlled by other parties in the relationship. In a regulatory setting, moral hazard can take a variety of forms. For example, if allowed revenues depend on observed costs, the regulated firm may have an incentive to inflate costs. ¹⁹ As another example, if it is costly for the firm (or its managers) to acquire information related to input prices or the likely impact of cost-reducing activities, the firm may have an incentive to shirk on the acquisition of such information. In designing regulatory policy, incentives for opportunistic behavior on the part of the firm must be taken into account. In this section, we consider several models in the recent literature that focus on regulatory policy when concerns about both moral hazard and adverse selection are present. Section 5.1 examines the design of optimal auditing policies when the firm must be motivated to engage in cost-reducing activities. Section 5.2 discusses the design of regulatory policy when the firm must be motivated to acquire valuable technological information.