Industry-Specic vs.

Antitrust Agencies: a
contribution on the institutional arrangement of
telecommunications policy

Ral Castro (raul.castro@econ.upf.es)

Universitat Pompeu Fabra
Version: July 2003
Abstract
In this paper, we focus on the choice from the institutional range
between pure Industry-Specic and pure Antitrust regimes in an in-
centive framework that highlights exposure to regulatory capture and
regulatory competence as the main driving forces. We show that the
trade-o faced by Government and Parliament in designing regulatory
infrastructure for business such as telecommunications is determined
by how dierent administrative controls of agencies are with respect
to their dierences in building eective regulatory competence. Ac-
cordingly, a dominant Industry-Specic Agency is the chosen pattern
when regulatory capabilities are considered the key factor for insti-
tutional design and the cost of raising public funds is large. Finally,
the choice of Industry-Specic Agencies has less demanding conditions
than for Antitrust Agencies, when they are compared with a solution
of regulatory separation that drive large eects of cost duplication and
intermediate improvement of collusion detection.
1 Introduction
Regulation of industries is generally performed under any of two broad insti-
tutional arrangements: generic institutions and legislation that are equally
valid to all or a wide range of sectors and industry-specic frameworks that
have their scope of action focused on a relatively well-dened group of sec-
tors
1
. Industry-specic regimes imply that either (i) certain issues of some
industries are regulated by a framework that is specic to them, while the

Revised version of a paper presented at the Business Workshop at the Universitat

Pompeu Fabra, Barcelona, December 1999. We thank Bruno Cassiman and Eduardo
Rodes for helpful comments. The usual disclaimer applies.
1
Another way to refer to this dilemma is as light-handed vs. heavy-handed regulation
respectively. They indicate the amount of rules and institutions that the industry faces.
1
rest of the industries are not regulated on those issues at all or (ii) those
specic frameworks include the same regulatory agenda applied to most of
industries (by generic agencies), but only they apply to a particular indus-
try or (iii) a combination of both. Industry-specic regulation is generally
associated to utilities and network businesses, which includes telecommuni-
cations, electricity, gas, airlines, water, railways.
We nd in the generic eld regulatory frameworks such as Labor,
Health, Competition, Fiscal, or Environmental Regulation.
In the specic case of telecommunications regulation, the division lines
between those institutional alternatives have been traditionally stable. How-
ever, since the late 1980s and 1990s, the choice of what institutional arrange-
ment should be used in regulating the above industries became a relevant
issue of discussion and analysis. Regulatory institutional arrangements in-
volve at least two features: regulatory jurisdiction assignment and communi-
cation channels among government bodies of the same or dierent regulatory
hierarchy
2
. Firstly, the worldwide process of privatization and liberalization
in telecommunications called for a reform of the regulatory framework to
support the success of both processes. In most of the cases, the preference
of industry specic regulation was renovated, although with the shift of reg-
ulatory responsibilities from central Government oces (Ministry Oces)
to, more or less, independent telecommunications-specic agencies. Sec-
ondly, in very few cases, the previous choice was reverted; either because
no industry-specic agency is created with liberalization (New Zealand) or
because years after their creation, the trend is towards a larger involvement
of generic regulatory frameworks (Australia and the UK).
In this paper, building on the Laont and Tirole (1993) framework, we
develop a model to analyze the conditions that promote the choice in the
spectrum between a pure Antitrust regulation and a pure Industry-Specic
regulation as well as the dierent combined arrangement of shared respon-
sibilities. In such framework, conditions of rents derived from asymmetric
information and non-benevolence of the regulator explain why the problem
of institutional design for regulation is relevant. Despite the model is spe-
cic to a business in particular, it has very straightforward implications for
telecommunications regulatory framework.
Why the choice between Industry-Specic and Antitrust regulation? In
telecommunications, the most frequent and largest degree of overlapping of
regulatory scope is usually between Industry-Specic Agencies (ISAs) and
Antitrust Agencies (AAs) and, consequently, it is one of the most relevant
dilemmas for institutional design
3
. Most of the issues of the regulatory
2
Laont and Martimort (1998)
3
In telecommunications, and for our purposes, a generic framework of regulation may
be implemented based on, not only antitrust enforcement, but also on a multisectoral
institution that acknowledges the convergence process in technologies and markets around
telecommunications (broadcasting, internet, content design and other network industries)
2
agenda of an Industry-Specic Agency have competition implications and
therefore are potentially subject of review by an Antitrust Agency. Even
some of the most complex issues of technology, network design or stan-
dard compatibility that are traditionally regulated by an ISA, also have
important implications for competitive dynamics. Scott (1998) argues that
the choice between both regimes reects a competition between groups of
theorists and practitioners: Regulatory and competition/anti-trust com-
munities are to some degree in competition with each other and oering
competing paradigms of oversight or construction of markets . The fol-
lowing subsections discusses on the case for assigning more jurisdiction to
either the Industry-specic Agency or the Antitrust Agency based on their
dierences in regulatory competence and transparency
4
Competence reasons for choosing an industry-specic regime
In general, the choice of industry-specic agencies tend to be based on rea-
sons of competence superiority to perform the regulatory job.
In some industries and specially in telecommunications, one of the main
reasons of such superiority is related to the context complexity. Telecommu-
nications has been considered a quite complex industry from a technological
point of view. Part of its regulatory agenda include setting technology stan-
dards, technology and demand implications of network externalities, cost
and quality eects of service interdependence, technical and competitive fea-
tures of unbundling network components, setting access conditions to new
players and spectrum management. These issues have critical implications
for the industry performance and require a degree of technical specializa-
tion and amount of resources so large, that might generate organizational
unbalances in a generic regulatory agency
5
.
Both Cave (1997) and Bergman et al (1999) highlight that the transition
period from monopoly to competitive market conditions in telecommunica-
tions requires prescriptive powers to face signicant regulatory complexity.
We interpret that one reason is that there are so many issues aecting the
development of competition, so many dilemmas aecting eciency and a
high speed of change in the business environment that prescriptive powers
would be preferred to simplify complexity
6
.
4
Analyzing allocation of regulatory powers among antitrust EC and member state in-
stitutions, Van den Bergh and Camesasca (2002) indicate: ...information asymmetries
between competition authorities and rms may argue in favour of descentralised compe-
tition policy. These benets in terms of reduction of infromation costs amy, however, be
outweighed by the increased danger of capture
5
OECD (1999) clasies the regulatory taks for network industries with three categories:
competition (antitrust), economic (prices and license issuing) and technical regulation.
The issues referred above mainly correspond to features of technical regulation.
6
The view of the British regulator OFTEL in its 1999 Guidelines for Competition Act
enforcement in telecommunications illustrates some of the peculiarities of the industry,
3
Related to the previous, a specic regulator would build industry-specic
information and professional competences faster than a generic regulator, be-
cause it would have a less dispersed policy agenda and face fewer diculties
to inuence Government resource allocation than being the industry section
of a broader institution. From this standpoint, the ISA would have better
chances to build eective regulation.
In practice, eectiveness of competition law enforcement might be also
insucient. One of the limitations is how lengthy its procedures tend to
be: the procedural framework in Antitrust requires more time for a nal
decision at the administrative level than in a specic-heavy-handed agency
7
.
In particular, comparing the speed of procedures of the Telecommunications
and the Competition Act in the UK, OFTEL (1999) considers the former a
faster route.
The agenda scope of AAs also becomes a competence limitation for
their eectiveness in telecommunications regulation. Antitrust Agencies are
there to build cases against transactions and practices dened as anticom-
petitive. Such framework drives two main limitations for managing and
enforcing Universal Service Obligations
8
(USOs): (i) USOs are usually in
conict with competition concerns and (ii) USOs management goes beyond
rule denition and involve administrative procedures associated to nancing
and allocating responsibilities of the system among rms. Performing such
tasks requires an institutional solution to problems of funding and asymmet-
ric regulation (all rms are not equally subject to certain rules
9
). Based on
that, Green and Teece (1997) consider that Universal Service is a key polit-
ical obstacle to complete the shift from regulation to deregulated markets.
Scott (1998) and Laont and Tirole (2000) also consider that a signicant
role of the social agenda and redistributive functions in telecommunications
regulation is an obstacle for moving its regime towards the antitrust frame-
work. As well as USO enforcement, Knieps (1997) and Shelanski (2002)
state that the enforcement of interconnection regulation and network com-
ponents unbundling as well as more service-based market competition rather
used to justify a special regulatory framework. They include (i) bottlenecks in network
access, specially local networks, (ii) very high xed and sunk costs and limited availability
of radio spectrum as sources of monopoly power, (iii) network economies, interoperability
externalities and call termination externalities gives quite specic peculiarities to telecom-
munications wholesale and retail demand and (iv) past features such as public ownership
and statutory monopoly for a long period of time determines that history matters in
telecommunications. See OFTEL (1999)
7
If antitrust enforcement is usually based on case-by-case investigations while the
industry-specic regulation uses prescriptive rules (applied to all cases), such dierence
between ex post and ex ante administrative processes would drive dierent lengths.
8
From Noam (1997): A universal telecommunciations service goal, simply dened, is
a public policy to spread telecommunications to most members of society, and to make
available, directly or indirectly, the funds necessary
9
Traditionally, universal service and social goals of telecommunications policy have
been assigned and performed exclusively by the larger operator of xed network.
4
than facilities-based competition drive signicant complexity that tend to
be better faced by the ISA.
Finally, the lack of proved experience of frameworks of pure generic reg-
ulation reduces its attractiveness to be replicated elsewhere. New Zealand
has been the main reference in the OECD of full replacement of industry-
specic regulation. Australia has been the main follower since 1989. This
limited number of illustrative examples supports the case for an industry-
specic framework, as far as the cost of implementation other arrangements
increases with the lack of international experience. Similarly, the increas-
ing importance of international coordination of regulation promotes insti-
tutional similarity: for example, regulatory institutions in EU forums or
in the International Telecommunications Union are usually industry-specic
agencies. However, we may still say that the reluctance towards such in-
stitutional redesign is also because the specic regulator itself usually leads
this process which may aect negatively its own ocials career.
10
.
Consequently, reasons associated to organizational matters, the speed to
learn and take decisions and eectiveness in managing USOs explain the
competence advantages of using an Industry-Specic regulator in a highly
complex context. However, despite the above reasons the Antitrust Agen-
cies may also oer other competence advantages as the ISAs. Assuming
antitrust enforcement more based on case-by-case investigations and the
industry-specic regulation more based on prescriptive rules (as we did
above), the former seems more adequate to oer telecoms a exible frame-
work of regulation which is required in context with fast technological and
market innovations
11
. Additionally, Dewatripont, Jewitt, and Tirole (1999)
show that the smaller and more homogenous set of tasks of the AA with
respect to the ISA drive incentives to perform a larger eort.
12
.
Although this arguments in favor of the AA may be incorporated in
the model, we work with the assumption that complexity is a key driver of
institutional design, making the Industry-Specic Agency a more eective
regulator who faces smaller costs to learn the relevant pieces of information
about the industry.
10
Following the previous point, the transformation in the US since the 1996 Telecom-
munications Act, despite the complex web of factors, illustrate an institutional movement
from a high antitrust involvement to a high FCC involvement
11
Soon (1997): The higher the degree of prescriptiveness the more allied the regula-
tion becomes to existing conditions and hence the more likely it is to become outdated.
Innovation in solving the problem that the prescriptive regulation seeks to address is hin-
dered because there is no incentive for the regulated party to do other than comply with the
prescription.
12
The paper analyzes how incentives of government agencies ocials are aected when
they face a multitask agency framework It nds that the larger the number of functions
(the more multitask and vague the agency), the lower the total eort performed by the
agency. This is a result of the damages that multiple tasks create on the linkage between
outside perception of talent and actual performance
5
Transparency reasons for choosing a (generic) antitrust regime
In general, several of the reasons that explain the choice of an antitrust
agency to regulate an industry are based on the advantages to drive trans-
parency in its performance and easier-to-control procedures. It reduces the
risk of collusion between the agency and the rm.
The specialization distance of antitrust agencies with respect to the
industry context, controls the risk of regulatory capture. Generic human
capital have more outside employment opportunities, which makes it less
attached to and dependent on one particular business. Consequently, the
revolving doors problem would be smaller than for specic human capital.
As a result, antitrust ocials would be less willing to participate in collusive
agreements with the industry and such larger bargaining power would drive
a smaller number of side-contracts than under the regulation of Industry-
Specic ocials. Similarly, antitrust enforcement would give new entrants
and other interested parties better opportunities to reduce their disadvan-
tage with respect to incumbents in terms of relationships with the regulator.
As the number of agents with expertise already built in antitrust procedures
and jurisprudence (as well as knowledge of agency ocials) would be
larger and more dispersed than in an industry-specic regulation
13
, the in-
formational rents of incumbents generated by specic assets in experience,
knowledge and relationships would be smaller. Consequently, the possibil-
ities of the agency to maintain side-contracts with a particular rm or a
portion of the industry are smaller.
Secondly, competition policy would be enforced by the regulatory body
specialized in such task. Priorities of contemporary telecommunications pol-
icy have evolved towards competition policy issues: interconnection agree-
ments, service resale, entry management, numbering portability, unbundling
of network components, mergers and strategic alliances, among others. By
denition, antitrust agencies have a larger expertise in competition issues
and policy than any other institutions; that is a source of advantage of the
generic solution in driving ecient regulation.
As a result of the previous, competition policy in telecommunications
would be more consistent with the policy applied to other industries; all
industries would face similar principles, methodologies and reasoning. In
particular, consistency and non-contradiction in competition policy enforce-
ment would be important among dierent industries that share conditions
of network externalities, essential facilities and asset specicity. On the con-
trary, ISAs are not subject to so strong consistency requirements
14
. Such
consistency of the competition policy with the approach applied in other in-
dustries increases the degree of transparency to the extent that it reduces the
13
An indication of this would be the larger number of consultancies and legal advisors
specialized in antitrust than in telecommunications policy.
14
Laont and Tirole (2000)
6
space for discretionary decisions and preferential rents derived from special
cases.
This is particularly important in the telecommunications business as the
boundaries of its relevant market are being redrawn permanently. This is
explained by a convergence process among telecommunications, broadcast-
ing, and internet from the service standpoint, as well as gas, railroads and
electricity from the infrastructure standpoint. Even if a specic agency is
chosen as solution, the business redrawing process generated by the con-
vergence process would also require redesigning the institutional scope of
regulation in order to fulll a minimum requirement of consistency among
the related businesses. Obviously, the result would be more generic and
closer to antitrust enforcement.
Similarly, Tiller (1998) show that agencies increase their policy discretion
through the strategic choice of instruments according to their diculty to be
reviewed. The superior industry knowledge of the ISA would allow it to face
the strategic choice of regulatory instruments (and forms side-contracts) in
more advantageous conditions than the AA.
The advantage attributed to single-task (as the AA) over broad-mission
agencies (as the ISA) because of their incentive to perform larger eort (as
explained above) is extended in Laont and Martimort (1998) in terms of its
lower "exposure" to capture: side-contracts with interest groups are easier
to be identied by outsiders and their generic knowledge is accompanied less
intense relationships and communication
15
.
In summary, the transparency superiority of the Antitrust Agency, as-
sumed bellow in the model, is based on the idea that more safeguards restrict
the space for discretionary changes by the AA than by the ISA. Such safe-
guards include a better knowledge of the framework by potential entrants
and outsiders, a larger jurisprudence, the requirement of policy consistency
across industries, better Checks and Balances framework, less exposure of
the antitrust ocials to revolving-doors problems
16
and its less competent
choice of hard-to-be caught instruments . This explains the model assump-
tion that the costs of administrative control are smaller for the Antitrust
Agency than for the Industry-Specic one.
In this paper, the regulatory capture model of Laont and Tirole (1993)
is used to build a framework of choice in regulatory design from the spec-
trum between a pure industry-specic and a pure antitrust regime. These
are institutional solutions frequently compared by practitioners
17
, but lack-
ing of a model that formalize the choice. In addition to asymmetric in-
15
Creating an anti-trust agency with a broad mission is bad if the centralized agency
keeps the same technologies for information acquisition as what would have bee available
to industry-specic agencies
16
See Heyes (1999)
17
See Bergman et al (1998), OCDE (1999), Scott (1998) and Shelanski (2002)
7
formation problems between the rm and regulator and across regulatory
hierarchies (New Regulatory Economics approach), dierences in regulatory
technologies are also considered. Consequently, both extremes of the insti-
tutional spectrum are dierentiated by their exposure to regulatory capture
and their eectiveness to build regulatory capabilities. Such dierence al-
lows the paper to contribute in the discussion of regulatory design with a
conguration that highlights the trade-o between regulatory eectiveness
and cost of agency control (transparency) as determinant of the institutional
choice from the spectrum.
In addition to a corner-solution context in which the AA or the ISA
are chosen as fully responsible, this paper also consider the case of joint
jurisdiction of the AA and the ISA. Traditionally this problem has been
mostly considered within the context of regulatory federalism
18
. However,
other literature developed from the Multiprincipal and Common Agency
approach for several organizational issues may also apply to institutional
design for regulation at the same geographical scope
19
. As Laont and Mar-
timort (1999), this paper also considers the Common Agency features of
splitting the regulatory responsibilities between two institutions; however,
they make each institution fully specic to a particular dimension of the in-
dustry
20
and this paper allows both institutions have overlapping (but not
identical) capabilities to regulate.
Although the structure of the model is not telecommunications-specic,
its application is quite straightforward. Firstly, the ISA and the AA char-
acterizations are very related to the telecommunication regulatory context:
technology and services are perceived as complex enough to value specialized
knowledge from regulators, telecommunications-specic agencies usually in-
clude very broad missions, complex rules
The model follows the well known three-layer structure, Principal-Supervisor-
Agent, used for regulation. The Principal corresponds with the Government,
the Parliament or the representative voter. The Regulatory Agency follows
the role of Supervisor. Finally, the Agent is the rm or the whole industry.
Note that this agent assumption simplies the competitive dynamics of the
industry.
18
Viscusi et al. (2000) and Van den Bergh and Camesasca (2002) provide useful discus-
sions on the federalism discussion on antitrust and regulatory enforcement in the US and
European context respectively.
19
See Gal-Or (1997) survey
20
Each institution is capable to learn about and regulate business dimensions of the
industry that the other cannot and viceversa
8
2 Model
Consider a Principal (Government) and an Agent (a Firm) contracting on
output and transfer t. Both are assumed to be risk-neutral.
The Agent: The objective function of the Agent is l = to, where o is
an eciency parameter. For simplicity assume o 2 fo
1
, o
2
g where o
1
o
2
.
The probability distribution is hr, 1ri. Therefore, the parameter r informs
how likely it is that the rm is of the inecient type. It can be interpreted
as an approximation of the innovation spillover environment of the industry,
to the extent that the larger 1 r, the more frequent the ecient rms are
and the more spread the innovation is among the industry players.
The Principal: The objective function of the Principal maximizes the
expected social welfare which is given by the sum of consumers utility o(),
where o
0
0 and o
00
< 0 plus the expected payo of the Agent minus
expected cost of public funds used in the contract:
\ = o() +1[l()] (1 +`)1[t] = o() o `

t (1)
where ` is the (strictly positive) opportunity cost of raising public funds, o
is the expected value of sigma,

t the expected value of transfers, and 1[.] is
the expected value operator.
The Supervisor: The contract can be dened such that the Principal
contracts a Supervisor (Regulator) with capabilities to uncover the relevant
pieces of information about the Agent for the contract enforcement. Dene n
as the transfer of the Principal to the Regulator when unknown information
is reported and normalize to zero her opportunity cost.
2.1 Model with Symmetric Information
At the moment of signing the contract, both Principal and Agent do not
know the value of o. When the transfer is paid both know that value.
The Principal maximizes social welfare in , t(o
1
) and t(o
2
) subject to
l(o
1
) 0 and l(o
2
) 0 (individual rationality constraint).
Proposition 1: The rst-best solution is described by
FB
such
that o
0
() = (1 +`) o and t(o
i
) = o
i

FB
for both , 2 f1, 2g .
21
From Laont and Tirole literature on regulation, we know that the in-
dividual rational constraint binds because public funds have an opportunity
cost, dened by `. Under a full information context, such opportunity cost
makes that the optimal result is obtained driving no rents to the agent.
The rst-best solution
FB
is found within a context of symmetric infor-
mation, which implies that the Principal has full access to such information
with no cost. Therefore, there is no real role for a Regulator. Alternatively,
21
The proofs of all propositions are in the appendix
9
the same result is obtained with an institutional setting in which the Reg-
ulator actually works when he is assumed to be benevolent. However, as
a building block for the case with asymmetry of information, let us con-
sider a Regulator in this model. Since there is symmetry of information,
the problem posed by a Regulator is trivial. The Principal maximizes social
welfare:
\ = o() +1[l()] +n (1 +`)(1[t] +n) = o() o `(

t +n) (2)
in , t(o
1
), t(o
2
), and n subject to l(o
j
) 0 for , = 1, 2 (individual
rationality constraint) and n 0 (regulator rationality constraint).
Proposition 2: The rst-best solution is described by
FB
such
that o
0
() = (1 +`) o, n = 0, and t(o
i
) = o
i

FB
for both , 2 f1, 2g
In a context such that the Principal contracts with the Regulator and
the Firm and none of them can hide relevant pieces of information from the
Principal, the result drives no informational rents. Consequently, the utility
obtained by both rm types and the transfer to the Regulator are equal to
zero and the obtained welfare does not have any incentive discount or
cost.
2.2 Model with Asymmetric Information
We need asymmetric information to get a more interesting result. In other
words, assume that the Principal does not know the true value of o when
the transfer is paid. Possibly the Principal faces a very high cost to learn
such information. Clearly, a type o
1
Firm is not a problem because it is
inecient. But a type o
2
Agent is a problem because by declaring to be
of the other type, she will make a gain (o
1
o
2
)
FB
. First-best cannot be
delegated! The role of the Regulator is no longer trivial, to the extent he has
an rm auditing technology that the Principal lacks of. Therefore, incentive
arrangements are required to make her reveal what she learns (as we will
see later, we will look for collusion-proof arrangements
22
).
To solve the problem with asymmetric information, we need to (a) nd
the separating equilibrium by backwards induction and (b) show that the
separating is better than the pooling equilibrium.
2.2.1 Separating Equilibrium
As expected from this three-layer structure, there are two sources of informa-
tion hiding: the Firm and the Regulator, and they require specic incentive
arrangements to prevent it. The incentives against regulatory capture are
considered in the Collusion section and in this section, we concentrate on the
implications of incorporating a (Firm) revelation constraint to the Principal
22
Laont (1994)
10
action. Type o
2
Agent is honest if and only if by lying bears an expected
loss 1 greater than the gain t(o
1
) t(o
2
).
This conguration represents a simplication of an implied process of au-
diting that drives hard information about the Agent with a probability, say
, that is in ]0, 1[ ,used by Laont and Martimort (1999), and 1 represents
the expected value of loss given by such probability. With this, instead of
working with two scenarios of income of the o
2
Agent depending on whether
the rm is discovered or not (that is, t
2
|o:: with probability and t
2
with
probability 1 ), we work with just one scenario: t
2
1, where 1 = |o::.
To enhance an expected loss 1, the regulator must have a monitoring and
auditing mechanism or technology that costs 1(1), where 1
0
0, 1(0) = 0,
1
0
(0) = 0, and 1
00
0. The intuition behind this function denition is
that the main cost driver of the monitoring activities is their degree of
complexity. The expected loss 1 is a proxy for it, because a large value is
calculated in function of large potential gains from hiding, which can nance
hiding sophisticated eorts of the rm. Additionally, ne setting could have
a clause of automatic accounting of the monitoring costs.
Expected social welfare (the objective function of the Principal) is given
by
\ = o() +1[l()] +n 1(1) (1 +`)(1[t] +n)
= o() o `(

t +n) 1(1) (3)

When comparing (2) and (3), the dierence is given by 1(1). Such reg-
ulatory costs are the resources invested to uncover the unobserved aspects
of the industry and become the welfare cost of an asymmetric information
context.
In this decision context, the Principal maximizes social welfare in ,
t(o
1
), t(o
2
), n, and 1 subject to l(o
1
) 0 and l(o
2
) 0 (individual
rationality constraints), n 1(1) (regulator rationality constraint), and
1 t(o
1
) t(o
2
) (revelation or incentive compatibility constraint).
Proposition 3: Dene r =
(1x)
1+
. If the marginal cost of audit-
ing 1
0
is greater than r,t
2
= o
1
; otherwise, t
2
= o
2
.
The reference value r =
(1x)
1+
represents the fraction of one unit of
the total cost of public resources that corresponds to the shadow cost of
resources transferred to an ecient rm, which might be considered as a
reference of the gains obtained from auditing the industry. Consequently,
the income transferred to the rm depends on whether the auditing cost of
the regulator are suciently nanced by such auditing gain.
Proposition 4: If 1
0
< r, the second-best solution (when there
is asymmetry of information) is described by
AI:1
such that o
0
() =
(1 +`)[ o +1
0
(o
1
o
2
)], n = 0, t(o
1
) = o
1

AI:1
, and t(o
2
) = o
2

AI:1
.
Proposition 5: If 1
0
r, the second-best solution (when there
is asymmetry of information) is described by
AI:2
such that o
0
() =
11
(1 +`) o +`(o
1
o), n = 1(1), t(o
1
) = o
1

AI:2
, and t(o
2
) = o
1

AI:2
The positive utility of the type o
2
Agent given by l(o
2
) = t(o
1
)o
2

0, includes the informational rent of such type of rm (given by (o
1
o
2
)).
When 1
0
r, the regulator owns an regulatory technology (or regulatory
assets) such that its auditing costs are too high to uncover false information
declared by the rm, no regulatory auditing is performed and the maximum
informational rent is allowed.
Proposition 6:The second-best solutions (with asymmetry of
information)
AI:1
and
AI:2
are always less than the rst-best so-
lution
FB
.
Information asymmetries, in any of its solutions, drive higher marginal
costs than in a full information context. Both, (1 + `)1
0
(o
1
o
2
) and
`(o
1
o), are additional marginal costs that reduce output in both scenarios
of regulatory auditing costs with respect to the rst-best level.
2.2.2 Pooling Equilibrium
The Government can also decide to avoid any regulatory eort to monitor
the industry performance. In this setting, this would imply the Government
avoids learning relevant pieces of information for its contract agreements
with the industry. Consequently, the contract is not contingent to anything
to be identied later on. In the model, this pooling solution drives t(o
2
) =
t(o
1
) = o
1
(and consequently 1 = 0).
By construction, the Government could have chosen this solution when
solving above. And the Government actually does it when 1
0
r, that is,
when auditing is too costly. Therefore, the separating must be necessarily
better than pooling equilibrium. In fact, as (1 + `)[ o + 1
0
(o
1
o
2
)]
(1 +`) o `(o
1
o), when regulation is performed, the output level under
separating is larger than under a pooling strategy of the Government.
2.3 Collusion
The separating equilibrium we have derived above is not collusion proof.
Why? Because, when regulatory auditing is performed, both the Regulator
and the Agent make zero gains whereas if they collude, they could share
t(o
1
) t(o
2
). A collusion proof equilibrium is achievable as long as the
expected loss from collusion osets the gain. Assume the Regulator is also
audited and, if colludes, it has an expected loss 1 (as in the case of 1, this
is a simplication of a process of Government auditing with a probability
of detection dierent than 1). To enhance an expected loss 1 the Principal
must invest T(1)(1 +`), where T
0
0, T(0) = 0, T
0
(0) = 0, and T
00
0.
Aiming at deriving a collusion proof equilibrium, we need to (a) nd the
collusion proof separating equilibrium and (b) show that it is better than
12
the separating equilibrium with collusion. Expected social welfare is now:
\ = o() o `(

t +n) 1(1) T(1)(1 +`) (4)

The Principal maximizes social welfare in , t(o
1
), t(o
2
), n, 1, and 1
subject to l(o
1
) 0 and l(o
2
) 0 (individual rationality constraint),
n 1(1) (regulator rationality constraint), 1 t(o
1
) t(o
2
) (revelation or
incentive compatibility constraint), and 1 t(o
1
) t(o
2
) (collusion proof
constraint).
Proposition 7: Dene r =
(1x)
1+
T
0
. If the marginal cost of
auditing 1
0
is greater than r, t
2
= o
1
; otherwise, t
2
= o
2
.
Note that the critical value under collusion-proofness constrains is smaller
than under the second-best result, because the latter is discounted by T
0
(in
the second-best result no Government auditing was performed and T
0
= 0).
As nancing the Government auditing of the Regulator implies shrinking
the gains from regulation itself; it makes the whole regulatory mechanism
more expensive and the Government (Principal) becomes more willing to
give rents to the ecient type of rm (Agent 2).
Proposition 8: If 1
0
< r, the collusion-proof equilibrium is de-
scribed by
CP
such that o
0
() = (1 +`)[ o +1
0
(o
1
o
2
)] +T
0
(o
1
o
2
),
n = 1(1), t(o
1
) = o
1

CP
, and t(o
2
) = o
2

CP
.
Proposition 9: If 1
0
r, the equilibrium is described by
AI:2
such that o
0
() = (1 + `) o + `(o
1
o)], n = 0, t(o
1
) = o
1

AI:2
, and
t(o
2
) = o
1

AI:2
.
As above, when the auditing technology is too expensive to be -
nanced by its marginal gain,
(1x)
1+
T
0
, the contractual setting does not
include a Regulator and the industry (or the ecient type of rms) enjoys
informational rents. In such case, the output contracted by the Govern-
ment is equal to the output contracted under Asymmetric Information with
no collusion-proof conditions; note that both drive the same regulation-free
context with a pooling solution.
Proposition 10: If 1
0
< r, the collusion-proof solution
CP
is
always less than the second-best solution
AI:1
.
Again, Government monitoring of the Regulator performance adds an-
other source of marginal cost. It reduces the output level under a collusion-
proof setting with respect to the second-best result, when 1
0
< r. Otherwise,
it is the same, since there is no regulatory enforcement mechanism. Actually,
what happens is that, now, the Government adds to the Regulator eorts
to overcome information asymmetries its own eort to overcome the non-
benevolence of the Regulator, requiring a smaller output to be sustainable.
2.3.1 Pooling Equilibrium
From propositions 5 and 9 we know that when regulatory auditing is too
costly or its gains are too small, the Government decides not to include a
13
Regulator in its industry contracts. Given its lack of competence to learn
relevant pieces about the industry, this would imply a pooling strategy of
contracting. Similarly, the non-regulation setting does not have any risk
of regulatory capture and such collusion-proof solution, by construction,
determines that no Government activity of auditing is required.
2.4 Types of regulatory regimes: Antitrust and Industry
Specic Regulation
Now we move to use the previous setting to analyze the dilemma between two
dierent types of regulators: an antitrust and an industry-specic one. The
rst section considers them as alternatives for a pure regulatory structure:
either the antitrust agency (AA) or the Industry-Specic Agency (ISA) is
chosen as the model for regulatory actions. The following section considers
the combined action of both models of regulations and the conditions in
which a combined regulatory setting is preferred to a pure one.
Both regulators, AA and ISA, are dened as dierent in the two main
dimensions of the model and based on the telecommunications characteriza-
tion from the above discussion in the Introduction: regulatory technologies
(regulatory eectiveness) and willingness to build eective side-contracts
with the industry (exposure to regulatory capture). In terms of the rst
dimension, the AA is assumed as less eective in auditing the industry than
the ISA, which means that 1
0
AA
(1) 1
0
ISA
(1) for all 1 0. The degree
of specialization of the ISA is given by a larger endowment of informational
assets about the industry or more specic expertise in monitoring it than
the AA. Additionally, the prescriptive approach of the ISA in telecommuni-
cations gives it advantages in dealing with the industry complexity and the
enforcement of Universal Service Obligations.
On the other hand, the ISA is assumed as more likely and capable to
build successful collusive agreements with the industry; this is a larger ex-
posure to regulatory capture. Above in the introduction, several arguments
have been considered to support such assumption. The revolving-doors phe-
nomena is particularly intense for the ISA; the AA is less competent to
make its strategic choice of regulatory instruments protected from admin-
istrative controls; the better knowledge, larger jurisprudence and enforce-
ment consistency across businesses of the Antitrust framework reduces the
agency discretion. Therefore, the cost of being audited by the Govern-
ment and being detected in its side-contracts is larger for the ISA than the
AA: T
0
AA
(1) < T
0
ISA
(1) for all 1 0. Note that the model assumptions
presented above imply a simplication of the dierences between both in-
stitutional solutions discussed in the introduction. In the model, regulation
enforcement of the AA is only focused on the telecommunications business,
which implied that its regulatory oversight on other sectors is not considered.
14
2.4.1 Anti-trust Regulation versus Industry-Specic Regulation
Propositions 8 and 9 provide a rule for including a Regulator or not in the
contract, which allows to analyze the suitability of each of the institutional
solutions considered, the AA and the ISA. If for both agencies 1
0
+ T
0

(1x)
1+
, auditing is too costly, none of them is chosen, the pooling solution
is optimal and hence there is no regulatory problem. Regulation does not
have any justication because every type of rm is considered behaving the
same way. If for only one of the agencies 1
0
+ T
0
<
(1x)
1+
, that should be
the chosen as Regulator. So the interesting case is when both have 1
0
and
T
0
so that we have a separating equilibrium for both types of regulatory
arrangement.
Dening the above notation of costs so that they are specic to each
agency, consider T
0
AA
and 1
0
AA
as the
0
: marginal costs of administrative
control and regulation respectively. Similarly, dene T
0
ISA
and 1
0
ISA
as the
1o
0
: marginal costs of administrative control and regulation respectively.
Assuming that for both agencies such costs drive separating equilibrium,
their rule of choice comes from identifying the one with the lowest marginal
cost: 1
0
AA
+T
0
AA
7 1
0
ISA
+T
0
ISA
.
Proposition 11:If 1
0
AA
+T
0
AA
< 1
0
ISA
+T
0
ISA
, the Regulator should
be AA; otherwise, it should be ISA.
This expression is an straightforward approximation of the relative de-
gree of cost advantage of an Antitrust regulator over an Industry-Specic
one. The smaller 1
0
ISA
+ T
0
ISA
(the larger the ISAs advantage), the more
likely that the ISA is preferred. Consequently, when 1
0
AA
+T
0
AA
1
0
ISA
+
T
0
ISA
, the output level under the supervision of an ISA is larger than un-
der an AA (because Industry-Specic operation is marginally less costly);
otherwise,
AA
<
ISA
(because the Antitrust framework is marginally less
costly).
Rewriting this rule, grouping the administrative costs and the regulatory
ones, 1
0
AA
1
0
ISA
< +T
0
ISA
T
0
AA
, makes the choice of the AA directly de-
termined by its lower relative cost of being audited and inversely determined
by the ISA smaller relative cost of monitoring the industry.
Let us consider the case in which ` = 0. This would imply that the
activity of raising public funds itself does not drive any ineciency and
Government transfers to the Firm and the Regulator (t and n) do not have
any cost premium. This would drive a net loss from regulating such that
1
0
+ T
0
0, which, as was stated above, would make pooling an optimal
solution. Regulation is not an issue because the cost of a regulatory set-
ting based on the chain of supervision of a regulator and the Government
(expressed by 1
0
+T
0
) becomes innitely expensive with respect to no gain
obtained from such activities. Similarly, as ` is an approximation of the
weight that the Government gives to collusive agreements as a problem of
15
welfare distribution, ` = 0 corresponds to a neutral attitude of the Govern-
ment to the problem that eliminates the motivation to regulate
23
.
What about the relevance of r? The lower r, the larger the gains from
establishing a regulatory setting for the industry, because a larger frequency
of rms of the most ecient type makes lying more likely and the transfer
cost of their eventual lying (and the savings from their supervision) larger
as well. Note that the intuition of this eect is related to the advantages of
building regulatory assets (knowledge investment) when a large technology
spillover reduces the obsolescence of such investment.
2.4.2 A solution with both Regulators
Let us now consider the possibility of having both regulators with concurrent
powers and call such institutional arrangement as regulatory separation
24
.
Consider 1
0
B
and T
0
B
as the consolidated marginal costs of auditing when
both Regulators coexist. Eventually both marginal cost function can be
written as weighted averages of the two corner solutions:
Marginal cost of auditing the rm: 1
0
B
(1) = c
0
1
0
AA
(1) + c
1
1
0
ISA
(1)
for all 1 0
Marginal cost of the Government auditing of the Regulator: T
0
B
(1) =

0
T
0
AA
(1) +
1
T
0
ISA
(1) for all 1 0
In a context in which both regulatory agencies do not have overlapping
competencies, Laont and Martimort (1999 and 1998) show that there exists
eects of improved administrative control
25
but also duplication of regula-
tory eorts. Consequently, we assume that the weights cs and s do not
necessarily add to one, because cost ineciencies would imply c
0
+ c
1
1
and the higher likelihood of collusion detection would imply
0
+
1
< 1.
Following the analysis in Proposition 11, we can compare the combined
regulatory setting with each of the unique regulator settings. As in such
analysis, marginal cost comparisons would determine which alternative is
preferred in each pair.
Comparing combined regulation and a pure Antitrust regulation, we nd
that if T
0
B
T
0
AA
1
0
AA
1
0
B
the pure Antitrust setting is less expensive
solution than any combined action of both agencies; otherwise some degree
of shared responsibility is recommended. Similarly, comparing regulatory
separation and a pure Industry-Specic regulation, we nd that if T
0
ISA

T
0
B
< 1
0
B
1
0
ISA
the pure Industry-Specic setting of regulation would be
preferred to any combined setting with an Antitrust regulator; otherwise
the shared responsibility solution is preferred.
23
See Jellal and Garoupa (2002)
24
See Laont and Martimort (1999)
25
Administrative control is improved with regulatory separation because of discretion
reduction and increase of transaction costs of regulatory capture
16
There are some issues to consider about:
In essence, the key decision driver on the institutional arrangements not
only comes from comparing the cost dierences of the Government auditing
with the cost dierences of the agencies regulatory technologies, but also
indicates which of both pairs of eectiveness tend to be more dierent among
the institutions: internal administrative controls vs. regulatory controls of
the industry. This interpretation might provide an explanation why the ISA
has been the dominant pattern of regulation. The involvement of the ISA
would be larger when the cost dierences of the Government auditing tend to
be smaller than the cost dierences of the agencies regulatory technologies.
This would be the case if, for example, the industry knowledge is what
mainly dierentiate a telecommunications agency from a competition agency
rather than their diculty to be controlled. Empirically, the latter makes
sense because agencies generally face the same mechanisms of administrative
control (enforced by the Government and/or the Congress) which determines
that the eectiveness of such administrative controls tends not to be as
dierent as their eectiveness of regulatory controls.
Secondly, the values of the parameters c
j
and
j
directly aect the range
from which each institution is chosen over any combined action of both
agencies. Each of them corresponds to only one of the marginal cost com-
ponents or institutional dimensions and one of the institutions might have
over-weighted its advantage or disadvantage factor or both, aecting sig-
nicantly its preference and leaving little space for any other solution. As
such weights reect the importance that society assigns to the institutional
dimensions of each agency, the strong preferences for a given institutional
solution might be also due to strong perceptions about the agencies, despite
their actual dierences in competence and transparency are relatively small.
Additionally, whatever the values of c
j
and
j
, they are a result of the
legal and administrative setting: who is in charge of the largest regulatory
agenda and who is supervised closer. Although they are aected by govern-
ment decisions that might change periodically, their substantive dependency
on the legal framework would make them relatively stable. For example, al-
though part of the responsibility assignment may change as easy as a cabinet
change or a government reform, basic issues are xed in legal pieces that
establish the regulatory setting. Similarly, most of administrative controls
are not specic to each agency but are enforced through general mechanisms
that oversee almost all government oces; this general scope makes them
harder to be changed.
Finally, let us assume harder conditions of cost duplications and in-
termediate improvements in Government auditing derived from regulatory
separation
26
.
26
This corresponds to the context in which the additional costs due to the jurisdiction
overlapping of agencies and their coordination are not suciently compensated by better
17
c
0
1
0
AA
+c
1
1
0
ISA
1
0
AA
1
0
ISA
T
0
AA
<
0
T
0
AA
+
1
T
0
ISA
< T
0
ISA
This scenario provides an adequate proxy of the decision to move from
one-agency solution towards a combined solution: in real world cases, dupli-
cation of regulatory costs begins since the moment that both agency share
responsibilities whereas the improvement of administrative control may take
longer.
We nd that, under such circumstances, it is always more likely to prefer
a pure Industry-Specic framework when it is compared with regulatory
separation (a both-agencies-regulate context) than when it is compared with
a pure Antitrust framework (corner solution context):
T
0
ISA
T
0
AA
T
0
ISA
T
0
B
1
0
AA
1
0
ISA
< 1
0
B
1
0
ISA
On the other hand, it is not clear whether the choice of a pure An-
titrust Agency arrangement is more likely when it is vis-a-vis a concurrent
arrangement than vis-a-vis a pure Industry-Specic one.
T
0
ISA
T
0
AA
T
0
B
T
0
AA
1
0
AA
1
0
ISA
1
0
AA
1
0
B
In a concurrence context, the AA choice becomes more attractive when
its advantage with respect to the eect of regulatory cost duplication (1
0
AA

1
0
B
) is larger than the AAs transparency attractiveness in corner solution
context due (T
0
ISA
T
0
AA
). As a result, Principals seeking to incorporate
the ISA specialized knowledge in AA issues enforcement have to balance
the improved auditing eect of concurrence with its cost duplication eect.
Empirically, concurrence of agencies usually do not avoid much of its cost
duplication as their costs appear since the rst day and few resource ad-
justment that drive its potential synergies are implemented. Therefore, the
strictness of this condition reduces the feasibility of the AA choice.
As it is accounted bellow, some degree of combined action of both insti-
tution is present in all country cases. Therefore, in analyzing the empirical
relevance of these results the comparative analysis with respect to concur-
rence arrangements seem more relevant than the decision rule between corner
solutions only..
The following list presents a synthesis of the results and statements.
1. The closer the conditions to a full information context, the closer the
industry prots and the regulator compensation to zero.
administrative control
18
2. The larger the shadow cost of public funds and the cost of administra-
tive controls, the less likely that industry regulation is performed and
larger the industry prots
3. The larger the industry innovation spillover, the more necessary a
regulatory setting of the industry.
4. The larger the dierence of the cost of administrative controls with
respect to the dierence in regulatory eectiveness of regulations, the
more likely that Antitrust is used as institutional solution.
5. The larger the shadow cost of public funds, the more likely that the
Industry-Specic framework is used as institutional solution.
6. When compared with a concurrence arrangement, the conditions for
preferring a pure Industry-Specic framework are less strict than for
preferring a pure Antitrust framework
The rst two implications are consistent with the results of Laont and
Tirole (1993). The following implications allows us to build a framework for
the institutional design within the spectrum of generic and industry-specic
regimes.
3 Concluding Remarks and Further Research
This paper has been focused on one particular feature of institutional de-
sign of regulation which is particularly relevant to the telecommunications
business: the choice of institutional arrangement from the spectrum of al-
ternatives between a pure Industry-Specic and a pure (generic) Antitrust
regime. The framework on which the discussion is built is the model of regu-
latory capture from Laont and Tirole (1993). In doing so, Industry-Specic
Agencies and Antitrust Agencies were dierentiated in terms of their regu-
latory competencies and their degree of exposure to capture by the industry.
In addition to comparing pure regimes, arrangements with some degree of
responsibility sharing (regulatory separation) were allowed.
The paper has shown that the preference of the institutional solution de-
pends on how dierent the advantage of the Antitrust Agency (AA) in costs
of administrative controls is with respect to the advantage of the Industry
Specic Agency (ISA) in costs of regulatory enforcement. In a Government
context that tends to standardize the eectiveness of its agencies control,
despite their signicant dierences in driving eective regulation, the pref-
erence for an Industry-Specic regime is enlarged. Moreover, if regulatory
competencies of agencies to face the industry complexity are perceived by
19
the Government as more important than their administrative control prob-
lems, the Industry-Specic regime will be always chosen.
Finally, it is also shown that, in a context of institutional concurrence
with large eects of cost duplication and intermediate improvement of ad-
ministrative controls, the conditions for preferring a pure Antitrust frame-
work are harder to fulll than for preferring a pure Industry-Specic frame-
work. An interesting implication is that it goes over the context in which
institutional reforms on certain regulatory domains leaded by one single
agency (pure arrangement) re-assign responsibilities to another agency with
concurrent involvement (mixed arrangement). For example, merger review
and competition policy enforcement are domains that the AA has tradi-
tionally leaded, as well as the ISA has leaded price regulation. The harder
conditions for AA than ISA for maintaining them in their current condition
of unique enforcer when the alternative is the concurrence both agencies,
helps to explain why empirical evidence in industries such as telecommu-
nications is signicantly concentrated on concurrent arrangements with a
leading part on the ISA
27
.
We nd that the discussion above drive issues which might become rel-
evant for additional research. For example, as in Laont and Martimort
(1999), there can be more than one dimension of the industry subject to be
learned by regulators. This would allow us to dierentiate the eectiveness
of one regulator to learn each of the pieces of information and nally make
it more or less specic to such dimension. In such case, we would maintain
the regulatory overlapping context used above but giving each agency ad-
vantages to regulate certain features of the industry with respect to other
agencies. The framework used in the present paper also simplies the compe-
tition process, and an approximation to it would probably expand the range
of determinants of the institutional choice. Similarly, costs of government
auditing are assumed exogenous and the shift towards making them as part
of the Principals optimization process would be relevant. The assumption
of Government benevolence is a limitation to analyze countries with large
imperfections in the political market. More obvious, the empirical review of
this discussion should be extended with respect to the list of case references
presented above. More detailed and comprehensive case studies and data
base on regulatory arrangements and institutional frameworks might help
in such task.
27
See Tyler and Bednarczyk (1993), Herguera and Stehman (1997) and OECD (1999)
20
Appendix
Proof of Proposition 1
Let us write the Lagrangian:
L = \ +j
1
l(o
1
) +j
2
l(o
2
)
The rst-order derivatives of this Lagrangian are:
L
q
= o
0
() o j
1
o
1
j
2
o
2
= 0
L
t
1
= `r +j
1
= 0
L
t
2
= `(1 r) +j
2
= 0
The second-order derivative of the Lagrangian is:
1
qq
= o
00
() < 0
This conrms that the derived result correspond to the maximum. From
the rst-order derivatives, it is clear that both constraints are biding, as j
1
and j
2
are positive, and o
0
() = (1 +`) o
Proof of Proposition 2
Let us write the Lagrangian:
L = \ +j
1
l(o
1
) +j
2
l(o
2
) +j
3
n
The rst-order derivatives of this Lagrangian are:
L
q
= o
0
() o j
1
o
1
j
2
o
2
= 0
L
t
1
= `r +j
1
= 0
L
t
2
= `(1 r) +j
2
= 0
L
w
= ` +j
3
= 0
The second-order derivative of the Lagrangian is:
1
qq
= o
00
() < 0
This conrms that the derived result correspond to the maximum. As above,
j
1
0, j
2
0 and j
3
0, which implies that their corresponding con-
straints are bidding; additionally, o
0
() = o +j
1
o
1
+j
2
o
2
is obtained
21
Proof of Proposition 3
Let us write the Lagrangian:
L = \ +j
1
l(o
1
) +j
2
l(o
2
) +j
3
[n 1(1)] +j
4
[1 t(o
1
) +t(o
2
)]
The rst-order derivatives of this Lagrangian are:
L
q
= o
0
() o j
1
o
1
j
2
o
2
= 0
L
t
1
= `r +j
1
j
4
= 0
L
t
2
= `(1 r) +j
2
+j
4
= 0
L
w
= ` +j
3
= 0
L
L
= 1
0
j
3
1
0
+j
4
= 0
It is clear that j
1
0, j
3
0, and j
4
0, that is, the three constraints
associated with these Lagrangian multipliers are binding. We can re-written
the following two rst-order derivatives:
L
q
= o
q
o [1
0
(1 +`) +r`]o
1
j
2
o
2
= 0
L
t
2
= `(1 r) +1
0
(1 +`) +j
2
= 0
The result now depends on 1. If 1
0
< r, we must have j
2
0 and the
constraint is binding. Conversely, if 1
0
r, we must have j
2
= 0 and t(o
2
)
takes the highest possible value, o
1
.
Proof of Proposition 4
From the previous proposition, we have that j
2
0 (the constraint is bind-
ing) if 1
0
< r. Consequently,
L
q
= o
0
() o [1
0
(1 +`) +r`]o
1
+ [1
0
(1 +`) (1 r)`]o
2
= o
0
() (1 +`)[ o +1
0
(o
1
o
2
)] = 0
And the result follows.
The second-order derivative of the Lagrangian is L
qq
= o
00
() (1 +
`)1
00
(o
1
o
2
)
2
< 0. This conrms that the derived result corresponds to
the maximum.
22
Proof of Proposition 5
From proposition 3, we have that j
2
= 0 (the constraint is not binding)
if 1
0
r. Consequently, t(o
2
) = t(o
1
), 1 = 0, 1 = 0, and 1
0
(0) = 0.
Re-arranging terms, we have:
L
q
= o
0
() o `o
1
= o
0
() (1 +`) o `(o
1
o) = 0
And the result follows.
The second-order derivative of the Lagrangian is L
qq
= o
00
() < 0. This
conrms that the derived result correspond to the maximum.
Proof of Proposition 6
From Proposition 2, the rst-best solution satises o
0
() = (1+`) o. In both
propositions 3 and 4, L
q
(
FB
) < 0. Therefore, it is necessarily the case that

FB
<
AI
.
Proof of Proposition 7
Let us write the Lagrangian:
L = \ +j
1
l(o
1
) +j
2
l(o
2
) +j
3
[n 1(1)]+
j
4
[1 t(o
1
) +t(o
2
)] +j
5
[1 t(o
1
) +t(o
2
)]
The rst-order derivatives of this Lagrangian are:
L
q
= o
0
() o j
1
o
1
j
2
o
2
= 0
L
t
1
= `r +j
1
j
4
j
5
= 0
L
t
2
= `(1 r) +j
2
+j
4
+j
5
= 0
L
w
= ` +j
3
= 0
L
L
= 1
0
j
3
1
0
+j
4
= 0
L
F
= T
0
(1 +`) +j
5
= 0
As above, j
1
0, j
3
0, and j
4
0, as well as j
5
0 which means
that their four corresponding constraints are binding. We can re-written
the following two rst-order derivatives:
L
q
= o
0
() o [1
0
(1 +`) +r` +T
0
(1 +`)]o
1
j
2
o
2
= 0
L
t
2
= `(1 r) +1
0
(1 +`) +T
0
+j
2
= 0
The result now depends on 1. If 1
0
< r, we must have j
2
0 and the
constraint is binding. Conversely, if 1
0
r, we must have j
2
= 0 and t(o
2
)
takes the highest possible value, o
1
.
23
Proof of Proposition 8
From the previous proposition, we know that j
1
0, j
3
0, j
4
0 and
j
5
0, (which implies that t(o
1
) = o
1

CP
and n = 1(1) ). Similarly, as it
is shown above, we have that j
2
0 if 1
0
< r; as the constraint is binding,
t(o
2
) = o
2

CP
. Consequently,
L
q
= o
0
() o [1
0
(1 +`) +r` +T
0
]o
1
+ [1
0
(1 +`) (1 r)` +T
0
]o
2
= o
0
() (1 +`)[ o +1
0
(o
1
o
2
)] T
0
(o
1
o
2
) = 0
And the result follows.
The second-order derivative of the Lagrangian is:
1
qq
= o
00
() (1 +`)1
00
(o
1
o
2
) T
00
(o
1
o
2
) < 0
This conrms that the derived result corresponds to the maximum
Proof of Proposition 9
From proposition 7, we have that j
2
= 0 if 1
0
r. Consequently, l(o
2
) 0
because t(o
2
) = t(o
1
). Similarly as in Proposition 3, 1 = 0, 1 = 0, and
1
0
(0) = 0 as well as T(0) = 0 and T
0
(0) = 0. Re-arranging terms, we have:
L
q
= o
0
() o `o
1
= 0
= o
0
() (1 +`) o `(o
1
o) = 0
And the result follows.
The second-order derivative of the Lagrangian is:
1
qq
= o
00
() < 0
This conrms that the derived result correspond to the maximum
Proof of Proposition 10
From Proposition 4, the second-best solution satises o
0
() = (1 + `)[ o +
1
0
(o
1
o
2
]. In proposition 8, L
q
(
AI:1
) < 0 (it satises o
0
() = (1 +
`)[ o +1
0
(o
1
o
2
)] +T
0
(o
1
o
2
)). Therefore, it is necessarily the case that

SB
<
CP
.
Proof of Proposition 11
The exercise is solved by comparing marginal costs for a given level of output
. Solving for the marginal costs, we can identify:
(1 +`)1
0
AA
+T
0
AA
= [(1 +`)1
0
ISA
] +T
0
ISA
(1 +`)(1
0
AA
1
0
ISA
) = T
0
ISA
T
0
AA
) `
C
=
T
0
ISA
T
0
AA
1
0
AA
1
0
ISA
1
24
Assuming that ` =

T
0
ISA
T
0
AA
R
0
AA
R
0
ISA
1 +-

`
C
, where - 0

1 +

T
0
ISA
T
0
AA
1
0
AA
1
0
ISA
1 +-

(1
0
AA
1
0
ISA
) T
0
ISA
T
0
AA
1
0
AA
T
0
ISA
1
0
ISA
T
0
AA
1
0
AA
1
0
ISA
+-1
0
AA

1
0
AA
T
0
ISA
1
0
ISA
T
0
AA
1
0
AA
1
0
ISA
+-1
0
ISA
And the result follows because 1
0
AA
1
0
ISA
.
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