Optimal Regulation in the Presence of Reputation Concerns∗

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 ” devel-ops, 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 invest-ment, thus mitigating the ”lemons problem ” and improving welfare