A Theory of Regulatory Fine Print

Abstract

We analyze a dynamic reputational model of regulation in which regulators are elected every period. Regulators signal that they are not captured by the regulated firm by designing a regulatory contract that appears to be less favorable to the regulated firm than their ideal contract. However, regulators compensate the firm by including clauses in the contract's fine print that transfer rents to the regulated firm by inefficiently distorting technical dimensions of the contract that voters do not observe or understand. Since the distortionary signaling is done by the regulators whose goals are more aligned with those of voters, this ``bad reputation'' effect reduces the expected benefit of replacing ``bad'' regulators and thus limits regulator accountability