Regulation of Selection Technologies

Overview & Synopsis

We analyze how a monopoly chooses the quality of a technology to select its consumers, when it is uncertain that the latter will comply with the legal rules required to buy its product. The firm may decide to exclude a consumer after observing a signal received on her compliance, which accuracy depends on the quality of the technology. The choice of the selection technology also impacts the consumers' incentives to comply with the legal rules. The firm incurs heterogeneous costs of serving compliant and non-compliant consumers, respectively. We explain why the firm's choice of the quality of the technology differs from the social optimum by extending the model of Veiga and Weyl (2016). Then, we use our model to assess whether the implementation of a fraud detection algorithm improves welfare. We analyze the role of several regulatory instruments to improve social welfare: the regulation of the selection technology, the ex ante regulation of the misclassification cost through sanctions, the ex post imposition of fines on non-compliant consumers.