This paper, authored by Jean-Jacques Laffont and Jean Tirole, explores the use of cost observation to regulate firms. The authors develop a normative theory for optimal incentive schemes, building on recent advances in non-linear pricing and abstract incentive theory. They assume that the regulator is a Bayesian statistician with prior knowledge about cost and demand conditions and aims to maximize expected social welfare under decentralized information. The paper introduces cost observability and an unobservable effort variable, focusing on a firm producing a public good. The planner observes the firm's output and cost but not its efficiency or effort levels. The firm's utility depends on output and cost, and it can reject the contract if it does not guarantee a minimum payoff. The authors derive the optimal incentive scheme, which is linear in ex-post costs, involving a fixed sum and a fraction of costs that decreases with output or increases with the firm's announced cost. They also analyze the implications of the optimal scheme for different scenarios, such as cost-plus-fixed-fee contracts and fixed-price contracts, and discuss the choice of technology and rate-of-return regulations. The paper concludes by comparing their findings with related work and highlighting the importance of cost observability in improving welfare.This paper, authored by Jean-Jacques Laffont and Jean Tirole, explores the use of cost observation to regulate firms. The authors develop a normative theory for optimal incentive schemes, building on recent advances in non-linear pricing and abstract incentive theory. They assume that the regulator is a Bayesian statistician with prior knowledge about cost and demand conditions and aims to maximize expected social welfare under decentralized information. The paper introduces cost observability and an unobservable effort variable, focusing on a firm producing a public good. The planner observes the firm's output and cost but not its efficiency or effort levels. The firm's utility depends on output and cost, and it can reject the contract if it does not guarantee a minimum payoff. The authors derive the optimal incentive scheme, which is linear in ex-post costs, involving a fixed sum and a fraction of costs that decreases with output or increases with the firm's announced cost. They also analyze the implications of the optimal scheme for different scenarios, such as cost-plus-fixed-fee contracts and fixed-price contracts, and discuss the choice of technology and rate-of-return regulations. The paper concludes by comparing their findings with related work and highlighting the importance of cost observability in improving welfare.