Liberal Regulation: Privatization of Natural Monopolies with Adverse Selection

This paper studies the effect of soft-budget constraints in a pure adverse selection model of monopoly regulation. We consider a govern-ment maximizing total surplus but incurring some cost of public funds à la Laffont Tirole (1993). We propose a regulatory set-up in which firms are free to enter natural monopoly markets and to choose their price and output levels as in the laisser-faire. In addition, the govern-ment proposes ex-post contracts to the private firms. We show that this regulatory set-up allows governments to avoid re-funding money-loosing firms and that welfare is larger than under traditional regu-lation where governments commits to both investment and operation cash-flows