Abstract
Who should be responsible for industry regulation, a private self-regulatory agency or a public agency? This paper provides a simple framework to analyze the optimal scope of a private self-regulatory organization (SRO) versus government regulation. The trade-off depends on three key elements: externalities, monopoly distortions, and the degree of asymmetric information. Self-regulation is more desirable than government regulation if the degree of asymmetric information between the public regulator and private industry is larger than the size of the monopoly distortion and externalities from the industry to society. An optimal mechanism consists of both self-regulation and government regulation where an SRO internalizes externalities within the industry and the government corrects any distortions generated by the SRO. These insights can be applied to many practical settings and policy discussions—for example, in the context of the financial sector, as with the Financial Industry Regulatory Authority.
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Notes
See “Remarks of Treasury Secretary Lawrence H. Summers to the Securities Industry Association” on Nov. 9, 2000 at http://www.treasury.gov/press-center/press-releases/Pages/ls1005.aspx.
See “Remarks of Lawrence H. Summers Director of the National Economic Council Responding to an Historic Economic Crisis: The Obama Program” on March 13, 2009 at https://www.brookings.edu/wp-content/uploads/2012/04/0313_summers_remarks.pdf.
For a detailed description for FINRA, see http://en.wikipedia.org/wiki/Financial_Industry_Regulatory_Authority.
Grajzl and Murrell (2007) also pursue the question of self-regulation versus government as an allocation of lawmaking power and identify conditions for improving social welfare.
To simplify analysis, I do not provide a micro-foundation for such externalities. In the applications, I provide examples to illustrate how such externalities might evolve.
It is the producers who should bear the blame for over-production because the externality term depends on total production by assumption. However, total production equals total consumption in equilibrium. Furthermore, it is possible that consumers are also responsible for the inefficiency if the externality term depends on total consumption.
Indeed, correcting externalities to consumers requires a reduction in production, the same result when the SRO exerts monopolistic distortion. However, the magnitude of reduction in production might differ. Furthermore, depending on assumptions, correcting externalities to consumers might call for an increase in production.
Similarly, one could ask the question of whether government regulation (self-regulation) is desirable compared to the unregulated competitive equilibrium. I answer this question by introducing the relative welfare function \(\Delta ^{CE/G}\) in Online Appendix.
See Online Appendix for details.
Similarly, one can show that the self-regulation does not automatically dominate competitive equilibrium, especially when the \(\Delta ^{S/G}<\Delta ^{CE/G}\).
One direct implication is that government can regulate both the consumers and producers to implement the first best allocation. For simplicity, Proposition 1 only considers regulations either on consumers or producers. For the analysis below, I focus on the regulations on the producer side.
In Armstrong and Sappington (2007), they summarize the insights about regulating a monopoly and claim that the first best can be implemented if the regulator knows consumer demand. Here in my settings, if the government knows the demand parameter \(\phi \), it can only implement the second best since the government also needs to know the externality parameter \(\Phi \).
For the nuclear industry, the competitor is the traditional power industry. For the securities industry, consumers can simply withdraw their money and put into a traditional banking account.
The externalities are even larger given the existence of deposit insurance and bailout funds.
For example, see the debate on how to regulate the Facebook in https://www.ft.com/content/0f2c8952-a719-11ea-92e2-cbd9b7e28ee6.
Think about the services provided by Google and Facebook. For the self-driving cars, consumers can always choose to drive by themselves.
Here, the interest rate R can be normalized to 1 due to the specific setting of an investor’s utility function.
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I am grateful to Anton Korinek, Olivier Jeanne, Laurence Ball, and Jon Faust for their encouragement and stimulating discussions. All errors are my own. I acknowledge financial support sponsored by Shanghai Pujiang Program.
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Ma, C. Self-regulation versus government regulation: an externality view. J Regul Econ 58, 166–183 (2020). https://doi.org/10.1007/s11149-020-09415-y
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DOI: https://doi.org/10.1007/s11149-020-09415-y