Dynamic incentive contracts with two-sided private information

The paper analyzes a dynamic regulatory model in which the regulatory policy may change over time and in particular it may become tighter. The model examines how this possibility affects the incentive scheme offered by the regulator. To this end we allow the regulator to have better information than the firm on the second-period policy. The main findings are the following. The rents necessary to induce separation are lower when there is a positive probability that the second-period policy will be tighter with a potential welfare gain. The problem of information transmission through the contract offer is more severe when the regulator has perfect information and this is common knowledge. This in turn implies that separation is less likely in this case and social welfare is smaller. Finally, social welfare may be higher in the noncommittment case than in the committment one. This is in sharp contrast with the result of the one-sided private information case.