Jean-Jacques Laffont and Jean Tirole, September 1989
Public decision makers are given a vague mandate to regulate industries. Restrictions on their instruments or scope of regulation affect their incentives to identify with interest groups and the effectiveness of supervision by watchdogs.
This idea is illustrated in the context of the regulation of a natural monopoly. Much of the theoretical literature has assumed that a benevolent regulator is prohibited from operating transfers to the firm and maximizes social welfare subject to the firm\'s budget constraint. The tension between the assumptions of benevolence and of restrictions on instruments in such models leads us to investigate the role played by the mistrust of regulators in the development of this institution. We compare two mandates: average cost pricing (associated with the possibility of transfers). The regulator may identify with the industry, but a regulatory hearing offers the advocacy groups (watchdogs) an opportunity to alter the proposed rule making. The comparison between the two mandates hinges on the dead-weight loss associated with collusion and on the effectiveness of watchdog supervision.