When is Knowledge Acquisition Socially Beneficial in the Laffont-Tirole Regulatory Framework?

Abstract

The Laffont-Tirole regulator observes the accounting costs of a firm but she can neither observe its true cost-type nor its chosen effort level. This paper considers a Laffont-Tirole regulator who could employ an expert to obtain better, albeit not perfect, knowledge about the firm's true cost type. Both the welfare gains through superior allocations from better knowledge but also the knowledge acquisition costs increase in the 'marginal deadweight losses from taxes' parameter λ ≥ 0. We derive a closed-form expression of the overall welfare benefits from knowledge acquisition as a function in λ. We characterize parameter conditions such that knowledge acquisition could improve social welfare in dependence on the value of λ. For this case we show that knowledge acquisition strictly increases social welfare if and only if λ falls into the interval (λ ∗, ∞) whereby we present a sharp characterization of the critical threshold-value λ ∗ ≥ 0. In other words, information acquisition through a regulator only increases welfare for economies with comparatively high deadweight losses from taxation whereas welfare is decreased whenever these deadweight losses are low.