CONTRACTING FOR PUBLICLY FUNDED SERVICES: UNMONITORED QUALITY AND EFFICIENCY ∗ KEVIN E. PFLUM † ABSTRACT. I analyze the optimal regulatory policy for a setting in which the service is provided by regulator funds and the contracted firm has superior knowledge of demand, which it can manipulate through its choice of quality. I show the conditions with which the firm can be induced to use its private information in the social interest. Because the firm can manipulate demand, however, the firm will generally extract an information rent, which is independent of the social cost of public funds. I further show how the firm’s objectives impact the optimal contract and what the regulator can achieve. The findings provide new insights into the conditions that lead to market distortions when there is asymmetric information. JEL Codes: H42, H57, L20, L31 Key Words: asymmetric demand information, regulating quality, for-profit and not-for-profit 1 Introduction It is well known that a regulated firm will extract an information rent resulting in a downward distortion in output when it has superior knowledge of its costs (see, for example, Myerson, 1979; Baron and Besanko, 1984; Laffont and Tirole, 1986). However, this result does not carry over to all situations in which the firm may have an information advantage. For example, Lewis and Sappington (1988) show that there will be no distortion from first best when a regulated firm has increasing marginal costs and superior knowledge of demand; and, Caillaud, Guesnerie, and Tirole (1988) show with an example of hidden effort and unobserved firm cost that the firm will provide the efficient level of effort if it is able to internalize all of the gains from exerting effort. The firm is not able to internalize the gains, however, when it is reimbursed based on observable costs and effort will be distorted away from the social optimum. Examples of such distortions abound in Laffont and Tirole (1993) who utilize a framework of compensation based on observable costs. 1 The purpose of this study is to add to our understanding of when asymmetric information gener- ates market distortions. I build off of Lewis and Sappington (1988) and Aguirre and Beitia (2004) * I am grateful to Paul J. Healy, Dan Levin, Lixin Ye, Huanxing Yang, Paula Cordero Salas, and seminar participants at the Ohio State University Microeconomic Theory Seminar for helpful comments and discussions. † University of Alabama, Department of Economics, Finance and Legal Studies, Box 870224, Tuscaloosa, AL, 35406, kpflum@cba.ua.edu. 1 See also Laffont and Martimort (2002) and Armstrong and Sappington (2004) for references to related models. 1