Regulation of Public Services with Non-Paying Consumers

This paper features a natural monopoly that faces non-paying consumers. A regulator, concerned not only by efficiency considerations but also about the consequences of allowing informal consumption, fixes the price to charge consumers and decides on transfers to the firm. In a full information scenario, the regulator also decides the effort level exerted by the firm to deter evasion. We study the regulation exercise when the regulator can neither observe the effort placed by the firm or observe the firm’s efficiency at placing such effort. Under a pure moral hazard scenario, delegation implies a lower level of effort than under full information. Moreover, delegation leads to distortions over the price level which depend on the relation of the price and the effort as complements or substitutes from the regulator’s point of view. When considering regulation under a pure adverse selection scenario, under certain premises, the optimal regular case mechanism is such that the effort and the price placed by the incumbent are both decreasing. The optimal mechanism under both the moral hazard and the adverse selection conserves features of both of the latter regulation exercises.