Bargaining and collusion in a regulatory model

Within a standard three-tier regulatory model, a benevolent prin-cipal delegates to a regulatory agency two tasks: the supervision ofthe Örmís (two-type) costs and the arrangement of a pricing mecha-nism. The agency may have an incentive to manipulate informationto the principal to share the gains of collusion with the Örm. Thenovelty of this paper is that both the regulatory mechanism and theside contracting between the agency and the Örm are modelled as abargaining process. While as usual the ine¢ cient Örm does not haveany interest in cost manipulation, we Önd that the e¢ cient Örm hasan incentive to collude only if the agencyís bargaining power is highenough, and the total gains of collusion are now lower than those thetwo partners would appropriate if the agency could make a take-it-or-leave-it o§er. Then, we focus on the optimal institutional responsesto the possibility of collusion. In our setting, where the incomplete-ness of contracts prevents the principal from designing of a screeningmechanism and thus Tiroleís equivalence principle does not apply, weshow how the playersíbargaining powers crucially drive the optimalresponse to collusion.