Mechanism Design under Collusion and Uniform Transfers


In this paper, we study mechanism design under collusion and uniform transfers focusing on the transaction costs in coalition formation created by asymmetric information among agents. We are particularly interested in the interaction between incompleteness of contracts and collusion: in our setting, the regulator (the principal) is constrained to use uniform transfers and this gives rise to room for collusion between the regulated firms. Collusion takes place under adverse selection and moral hazard since each firm's cost, observable to the regulator, is determined by its efficiency parameter and by its effort, which are the firm's private information. We first show that when the gains from collusion are smaller than a threshold, the firms fail to realize the gains because of the transaction costs created by asymmetric information. When the gains are larger than the threshold, we characterize the optimal collusion-proof mechanism which fully exploits the transaction costs. Finally, we show that when the regulator is constrained to use uniform transfers, the collusion-proofness principle does not hold.

Published as: Monetary policy and exchange rate volatility in a small open economy in Review of Economic Studies , Vol. 72, No. 3, 707-734, July, 2005