The optimal regulation of a risky monopoly

We study the potential conflict between cost minimization and investment in prevention for a risky venture. A natural monopoly is regulated i) for economic purposes; ii) because it can cause losses of substantial size to third parties (the environment or people). The regulator observes the production cost without being able to distinguish the initial type (an adverse selection parameter) from the effort (a moral hazard variable). In addition, the investment in prevention is non observable (another moral hazard variable) and the monopoly is protected by limited liability. We fully characterize the optimal regulation in this context of asymmetric information plus limited liability. We show that incentives to reduce cost and to invest in safety are always compatible. But, in some cases, higher rents have to be given up by the regulator.