Staff Report 464

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Optimal Regulation in the Presence of Reputation Concerns

Andrew Atkeson - Consultant
Guillermo L. Ordonez
Christian Hellwig

Published February 27, 2012

We study a market with free entry and exit of firms who can produce high-quality output by making a costly but efficient initial unobservable investment. If no learning about this investment occurs, an extreme “lemons problem” develops, no firm invests, and the market shuts down. Learning introduces reputation incentives such that a fraction of entrants do invest. If the market operates with spot prices, simple regulation can enhance the role of reputation to induce investment, thus mitigating the “lemons problem” and improving welfare.

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