Seminar

Optimal Regulation in the Presence of Reputation Concerns

Guillermo Ordonez (Yale University)

March 15, 2010, 17:00–18:30

Toulouse

Room MF 323

Political Economy Seminar

Abstract

We study a market with free entry and exit of firms that can costly invest in their quality. If the investment is observable, the first best is characterized by high quality and a large output. If the investment is non observable, free entry creates adverse selection, blocking market existence. If buyers learn over time about firms’ quality, reputation formation allows firms to recover their investment in expectation and the market exists. However quality and output are low. We show that, if the government have the same information as the market and can commit to a schedule of taxes and subsidies, it can achieve an allocation arbitrarily close to the first best. Moreover, even if the government has less information than the market, and for example only observes entry, it can still improve welfare by imposing entry costs. However, in this last case there is a trade-off between quality and output that prevents being close to the first-best.