Monday, October 6, 2014
Brian Galle (Boston College) presents The Price of Knowledge: Regulatory Design in an Uncertain World at Florida today as part of its Graduate Tax Program Colloquium Series:
I examine a regulator’s choice of how and when to regulate when marginal costs and marginal social benefits of compliance vary across regulated parties and are costly to observe. Recent commentary suggests that heterogeneity of marginal cost favors “carrots” over “sticks.” Other commentary argues that heterogeneity of marginal social benefit may favor ex post over ex ante regulation, or may weigh in favor of “command and control” regulation rather than either sticks or carrots. While these recent papers add important nuance to the regulatory design literature, I argue here that their analysis overlooks several other critical factors that may alter their final policy recommendations. For example, I show that when marginal cost varies and moral hazard is possible, optimal government policy is a mix of stick and carrot, much as the optimal insurance contract provides for some co-payment by the insured. Ex post regulation does provide useful additional information when regulated parties are heterogeneous, but also carries significant and sometimes prohibitive social cost, especially when externalities are produced by limited-liability firms. Further, drawing on results from mathematical simulations, I show that the costs of heterogeneity can be sharply reduced even with a small degree of government flexibility. I apply these insights to a series of examples, including the pending U.S. cap-and-trade regulations, fat taxes, and the regulation of systemic risk in the banking sector.