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We develop an agencytheoretic approach to interest-group politics. We study the potential identification of a regulatory agency with the interests of a regulated firm and of non-industry groups. We show that: (1) The organizational response to the possibility of agency politics is to reduce the stakes the interest groups have in regulation. (2) The threat of producer protection leads to low-powered incentive schemes for the regulated firm. (3) Consumer politics may induce uniform pricing by a multi-product firm. (4) The power of interest groups is not determined by a supply-and-demand theory, in which regulation is captured by the interest group with the highest willingness to pay. First, the regulatory inefficiencies associated with the pressures of several interest groups may compound rather than cancel. Second, the power of an interest group does not depend only on its willingness to pay, i.e., on the combination of its stake in the regulatory decision and of its cost of organizing and of influencing government, but also on the kind of influence it wants to exert. The group has more power when its interest lies in inefficient rather than efficient regulation, where inefficiency is measured by the degree of informational asymmetry between the regulated industry and the external monitor (Congress).

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The paper studies a simple two-period principal/agent model in which the principal updates the incentive scheme after observing the agent's firstperiod performance. The agent has superior information about his ability.The principal offers a first period incentive scheme and observes some measure of the agent's first-period performance (cost or profit), which depends on the agent's ability and (unobservable ) first-period effort. The relationship is entirely run by short-term contracts.In the second-period the principal updates the incentive scheme and the agent is free to accept the new incentive scheme or to quit.The strategies are required to be perfect and updating of the principal's beliefs about the agent's ability follows Bayes ' rule.The central theme of the paper is that the ratchet effect leads to much pooling in the first period. First, for any first-period incentive scheme, there exists no separating equilibirum. Second, when the uncertainty about the agent's ability is small, the optimal scheme must involve a large amount of pooling. The paper also gives necessary and sufficient conditions for the existence of partition equilibria.

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