7th Seminar Assignment
by Espen Nord Eidene and Simen Pedersen
Summary of the article ”Coase versus the Coasians” by Glaeser, Johnson and Shleifer (2001)
by Espen Nord Eidene and Simen Pedersen
Question 1.1
Main Points of the Theoretical Part of the Paper (Simen)
The paper presents a theoretical model that sheds light on the trade-off between enforcement by judges that is relatively weak but unbiased and the enforcement by regulators facing stronger but possibly biased incentives.
Regulator versus Judges
The crucial distinction between judges and regulators is that the regulator can be more easily provided with incentives to punish violators of particular statutes. Judges, in contrast, is more independent and it follows that it is harder to motivate them. The stronger the incentives are for the regulators have the gain of bringing about more aggressive enforcement than that from the court.
A Model of Enforcement Incentives
Situation
The government wishes to punish particular conduct creating a negative externality. For example a broker that manipulates the marked.
Key question
Do the government want the adjudicator to be a judge or a regulator?
Assumptions
- Society doesn’t have full control over the incentives facing the law enforcement officer.
- Doing justice is largely unverifiable. Then it follows that it is hard for the society to reward the adjudicator for enforcing the law.
The adjudicator (A)
- A can be a judge or a regulator
- For a personal cost c>0 can A investigate (search), and find out for sure whether a violation had taken place.
- A has complete discretion as to whether to penalize the potential violator, and can do this without searching.
- A derives b from following the law (which means punish a violator or letting go an innocent person)
- A derives a payoff a for each suspect he punish, even if the suspect is innocent. a=0 means that the adjudicator only care about justice.
p is the probability for a suspect person to be a violator and (1-p) is the probability for a suspect person to be innocent.
We can from this put up the payoff matrix with a>0:
Not punish / Punish / ProbabilityInnocent / b / a / 1-p
Guilty / 0 / a+b / p
And the payoff matrix when a=0:
Not punish / Punish / ProbabilityInnocent / b / 0 / 1-p
Guilty / 0 / b / p
From this could we investigate the A`s expected payoff from three different strategies:
(1) Search (S) => Convict the guilty and not convict the innocent
(2) Leniency (L) => No search, no punishment to any of the suspects
(3) Abuse (A) => No search, convict all suspects
A`s expected payoff
When a = 0:
When a>0:
We assume that a>0 and fix b and p. From this can we can answer the following question.
ð When is leniency better than abuse?
ð When is search better than leniency?
ð When is search better than abuse?
Intuition from this
ð For low-powered punishment incentives and high-cost of search, the adjudicator chooses leniency.
ð For high-powered punishment incentives and high-cost of search, the adjudicator chooses abuse.
ð A only chooses search as long as the cost of investigation is so low that he/she prefer search to leniency and search to abuse.
Figure
Results from the Model
The model shows that, relatively to judges, regulators may be motivated to invest in understanding the laws and circumstances of a case. More likely will the regulator, if over motivated, reach politically desirable decisions at the expense of doing justice. It also shows how decreasing the cost of the investment in information by law enforces can improve enforcement efficiency.
Main Points of the Empirical Part of the Paper (Espen)
Illustrates the model by comparing the regulation of securities through corporate and securities law in Poland and Check Republic. Uses a lot of time on explaining the historically parallels. Previous part of the Soviet Union, communism, independently at nearly the same time. Poland more stringent in regulation of securities law than Czech. More lax regulation in Czech also enforced through an unmotivated Ministry of Finance.
Specially, they apart in two stances. First, the Czech large scale voucher privatization was faster and more extensive than Poland. Secondly, Poland grew faster and had a higher rate of inflation than Czech. Besides these two stances, the authors summarize that the economies and economic policies of the two countries share some remarkable similarities.
Company law
Poland s company law more protective of minority shareholders than the Czech law.
Securities and law
They use different approaches to reform in terms of the government’s interest in regulatory intervention. The paper focus on two issues in analyzing the securities of laws. First, great independence and power of regulators is increase of the a in the model; increasing the incentives of the adjudicator. Secondly, greater mandatory disclosure, and use of intermediaries to enforce it is a reduction in the cost of investigating, c. They say;
«Evidence shows that Poland chose to regulate its securities markets more stringently than the Czech. Its law provided the extensive disclosure of financial and ownership information. In our model, a reduction in c. Additionally, Poland relied on administrative control over markets by a motivated securities regulator, in the model viewed as an increase in a. »
Discussion
They point out problems in the Czech financial markets compeered to the Polish.
In Czech Republic: laxity of the securities law accommodated tunneling. By this, it follows several inefficient outcomes. First transactions did not take place on an exchange and therefore change hands at a price different from the market price. Secondly, majority shareholder often played a dominant role which may not have taken place in a country with more efficient judicial system and more interested securities regulators. This made the owners and manages more capable to exploit the inside values of the firm and their positions, than in Poland, which also made financial scandals occur more often in Czech than Poland. They launch another explanation to why the countries have developed different; they chose a darwinstic kind a like strategy; «let's go private with all firms and the ones who best adapt the market will survive. » They argue at the end of the discussion part that it boils down to a radical improvement of the courts, represented by b in our model. Regulation can serve as a substitute for the judicial enforcement of private contracts and laws.
Their conclusion consists of three parts
1. Financial markets are helped by the legal protection of outside investors from expropriation by issuers and financial intermediaries
2. Evidence is consistent with the prediction of the model that an important element and investor protection is the disclosure of information by issuers and intermediaries. This is often mandated by securities laws and thus plays a key role in investor protection.
3. Who should enforce laws? Regulators or judges? In emerging markets where costs of verifying information are high and interpreting statutes are difficult, it might be best to leave the work to regulators.
Question 1.2 (Espen)
Discuss the judicial vs. regulatory enforcement of contracts
The paper discuss the extreme values of a and b. i.e. equal to zero and very high value.
An important factor in the model is the trade off when setting a and b. Consider a, which is payoff from each suspect being punished. If a=0, then there's no private gain, only looking for true justice. In this case, there will be very few convicted, due to the extreme goal of only true justice. A result of this can be that they don't put in to much effort in the work, since investigating will be followed by a cost c. On the other hand, a too high a will end up with too many innocent people convicted due to the high payoff a adjudicator will get from punishing violators. The same trade-off yields asymmetrical also for b.
Also pointed out, is that the model is set up to capture private, rather than social payoffs.
What about the reputation of a judge or regulator? This model is set out with only choosing strategy once. A dynamic dimension is missing. Then it also should include parameter which captures the reputation of a adjudicator, possibility to change the values of a,b,c when other values are better suited in order to fit the actual situation in an economy. (As in the paper, when transitory economies develop in a positive direction it will be plausible that a system made 5 years ago not is the optimal today). We mean that a dynamic dimension will capture the behavior in reality in a better way than a static model will. Then, a person with authority also must see the trade off of a better reputation (after convicting just violators) and payoff.
Question 1.3(Simen)
Role of the legal error in the model
In this setting a legal error is a case where:
1. A guilty is not punished (type 1 error)
2. A innocent is punished (type 2 error)
When the adjudicator choose the strategy abuse there will be a probability p of type 1 error, and if he/she chooses the strategy leniency there will be a probability (1-p) for type 2 errors.
The socially optimal outcome, where the probability for a legal error is zero, will be a solution when the adjudicator chooses the search strategy.
From question 1.1 (and the figure) we see that this will be the case when:
for
and
for
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