Regulatory Rule-Making with Legal Challenges

We study optimal regulatory rule–making when firms can challenge regulations in court. As in the usual analysis, the firm has private information regarding its production costs. We show that there are three cases of interest. In the first, the regulator precludes challenges by simply adding a constant to the transfer to the firm as calculated according to the usual second–best. Here challenges create a type–independent tightening of the individual rationality constraint. In the second case, the regulator again chooses to preclude challenges, but the tightening of the individual rationality constraints is type dependent. Here the outputs also differ from the usual second–best. Finally, the regulator may choose not to preclude a legal challenge because challenges are too costly to preclude or simply because the information generated by the legal process is useful. Intuitively, the least efficient firms have the most incentive to challenge regulations. Hence if the regulator chooses not to block challenges, she can more easily prevent efficient firms from imitating less efficient ones, but at the cost of the associated legal fees. In this case, it is possible for the regulator and the firm to be better off than in the usual second–best because of the extra information generated by the hearing.