Essays on Market Intervention and Regulation

Abstract

This dissertation is a theoretical exploration of commonly used policy tools meant to improve market performance. The first chapter examines the use of prizes and grants as instruments for encouraging research and development. The second chapter investigates the welfare impact of price caps in oligopoly markets with endogenous entry. The third chapter studies the relationship between deposit insurance and bank risk taking, when a banker is motivated by reciprocity. The first chapter explores the use of grants and prizes as tools for encouraging research activity and innovation. Grants and prizes are commonly used by public and private research funders, and encourage R&D activity in different ways. Grants encourage innovation by subsidizing research inputs, while prizes reward research output. A common rationale for prizes is moral hazard; if a funder cannot observe all relevant research inputs then prizes create a strong incentive for R&D activity. In this chapter, it is shown that grants are a more efficient means of funding when a researcher's ability is unknown to the funder (adverse selection). When both adverse selection and moral hazard problems exist, a grant may emerge as an optimal funding mechanism, provided the moral hazard problem is relatively weak. In settings where the moral hazard problem is sufficiently strong, a grant emerges as part of an optimal funding mechanism, in conjunction with a prize. These results are useful for understanding different funding mechanisms used by both public and private entities. The second chapter, which is based on joint work with Stan Reynolds, examines the impact of price caps in oligopoly markets with endogenous entry. In the case of deterministic demand, reducing a price cap yields increased total output, consumer welfare, and total welfare. This result falls in line with classic results on price caps in monopoly markets, and with results for oligopoly markets with a fixed number of firms. These comparative static results for price caps need not hold when demand is stochastic and the number of firms is fixed, but recent results in the literature show that a welfare improving price cap does exist. We show that a welfare-improving cap need not exist in the case where demand is stochastic and entry is endogenous. In addition, we provide restrictions on the demand function such that a welfare-improving price cap exists under endogenous entry and stochastic demand. The third chapter, which is based on a joint project with Martin Dufwenberg, investigates the relationship between deposit insurance, risk taking, and insolvency. Empirical evidence suggests that the introduction of deposit insurance increases risk taking by banks and results in a greater chance of insolvency. The common rationale for this connection is that deposit insurance decreases the incentive for customers to monitor their banks, and invites excessive risk taking. In this chapter, it is argued that this classic explanation is somewhat puzzling. If customers can monitor their bank's behavior, certainly the insurance provider (FDIC) has this same ability. If this is the case, appropriate mechanisms could limit the moral hazard problem. We put forth an alternative explanation, and demonstrate that deposit insurance invites excessive risk taking when a banker is motivated by reciprocity.