This paper analyzes the optimal regulation of firms using cost observation as a tool. The authors, Jean-Jacques Laffont and Jean Tirole, examine how a regulator can design incentive schemes to influence firm behavior, particularly in the context of public goods and private monopolies. The study is based on a model where a firm produces a public good, and the regulator observes the firm's output and cost but not its efficiency, effort, or cost disturbances. The regulator aims to maximize social welfare by designing an optimal incentive scheme that accounts for the firm's risk preferences and the regulator's information constraints. The paper introduces a model where the firm's output and effort are chosen to maximize its payoff, considering both the firm's efficiency and the regulator's incentives. The regulator's objective is to maximize expected social welfare under the constraint of decentralizing information. The optimal incentive scheme is found to be linear in ex-post cost, with the regulator paying a fixed sum and then reimbursing a fraction of the firm's costs. This fraction is inversely related to the fixed transfer and decreases with the firm's output or efficiency. The authors show that the optimal contract can resemble a cost-plus-fixed-fee or fixed-price contract, depending on the regulator's concern for output. They also discuss the implications of cost observability and the role of risk aversion in the firm's behavior. The paper concludes that the optimal allocation can be implemented through a linear scheme, which is robust to various forms of cost uncertainty and is particularly effective when the firm's efficiency is high. The study highlights the importance of cost observation in regulating firms and provides a framework for understanding how regulators can design incentive schemes to achieve optimal outcomes. The results have implications for various regulatory contexts, including public goods provision, private monopolies, and the design of contracts in the presence of incomplete information.This paper analyzes the optimal regulation of firms using cost observation as a tool. The authors, Jean-Jacques Laffont and Jean Tirole, examine how a regulator can design incentive schemes to influence firm behavior, particularly in the context of public goods and private monopolies. The study is based on a model where a firm produces a public good, and the regulator observes the firm's output and cost but not its efficiency, effort, or cost disturbances. The regulator aims to maximize social welfare by designing an optimal incentive scheme that accounts for the firm's risk preferences and the regulator's information constraints. The paper introduces a model where the firm's output and effort are chosen to maximize its payoff, considering both the firm's efficiency and the regulator's incentives. The regulator's objective is to maximize expected social welfare under the constraint of decentralizing information. The optimal incentive scheme is found to be linear in ex-post cost, with the regulator paying a fixed sum and then reimbursing a fraction of the firm's costs. This fraction is inversely related to the fixed transfer and decreases with the firm's output or efficiency. The authors show that the optimal contract can resemble a cost-plus-fixed-fee or fixed-price contract, depending on the regulator's concern for output. They also discuss the implications of cost observability and the role of risk aversion in the firm's behavior. The paper concludes that the optimal allocation can be implemented through a linear scheme, which is robust to various forms of cost uncertainty and is particularly effective when the firm's efficiency is high. The study highlights the importance of cost observation in regulating firms and provides a framework for understanding how regulators can design incentive schemes to achieve optimal outcomes. The results have implications for various regulatory contexts, including public goods provision, private monopolies, and the design of contracts in the presence of incomplete information.