Combining Economics and Psychology - Corporate Governance and Business Ethics

In summary, complexity is costly. For most people most of the time there is a direct psychic cost of dealing rationally with complexity. Secondly, it takes longer time to adapt to complex rules. Third, complexity increases the probability of costly mistakes to a near certainty. However, bloodedly rational human actors can economize on these costs in numerous ways, and corporations, which have more resources at their disposal, have an even wider choice of strategic options at their disposal.

Non-compliance

Companies can ignore the complexity and continue as they used to. If enforcement and penalties (direct and indirect) are weak, this will often be a cost efficient response for the regulated. For more serious offences this will often be too costly, but despite of this a non-trivial share of the population will usually decide not to comply. Non-compliance may be naïve, but it may also be disguised by deliberate camouflage. For example, top managers may make a formal decision to comply without providing the resources necessary to comply down in the organization and then letting middle managers or other scapegoats take the blame. From the viewpoint of the regulator, this is obviously costly because camouflage is a waste of resources, because more resources will have to be invested in enforcement and because alternative, less complex regulation would perhaps be more cost-effective.

Nevertheless it would probably be an exaggeration to assume that noncompliance is generally the result of a cost-benefit analysis. Non-compliance may equally well be the result of psychological pathologies like denial or learned helplessness.

Rule Adoption

If companies decide to go by the book, this will be costly, because complex learning takes time and effort. They may reduce these costs by imitation of routines adopted by other companies, which will save on development costs, but involves a risk that the borrowed routine will not be a good fit with the company. Alternatively, they may outsource problem solving to advisors auditors, lawyers etc. who specialize in dealing with regulation complexity. Professional advisors can play an important role in the diffusion of legitimate, standardized solutions to complex problems.

Again, rule adoption may represent other forces than cost-benefit analysis. Herding in the sense that all firms adopt the same standards involves some insurance since it does not affect the competitive situation, if companies are similar. The costs of rule adoption include both disutility, advisor fees, opportunity costs of time and effort and the costs of imposing uniform, one-size-fits-all standards on company behavior (e.g., board work). In the case of corporate governance regulation there are many examples of firms which adopt rules and standards that are not fitted to their situations. Family firms for example often adopt board structures (e.g., independent boards and audit committees), which are intended as a solution to the separation of ownership and control (which is less relevant in family businesses).

Exit and Relocation

Sometimes it is possible to escape regulation by relocation or exit. Plants subject to complex environmental regulation may be closed down or moved to other countries. The same kind of regulation arbitrage may be possible, if there are different regulation regimes within countries, for example listed companies may decide to go private. Obviously, these strategies are also costly. For example, there are private and social costs of closing down production, and firms going private miss the benefits of risk diversification. Exit and relocation strategies have been widely used in the US following Sarbanes-Oxley. Many listed firms have chosen to go private, and fewer foreign firms have their shares listed in the US (Hubbard 2007). Schuck (1992) points to examples where the concerned parties choose to contract around legal complexity, for example when farmers in Shasta County California choose to resolve their disputes outside the law (Ellickson 1991). Private equity funds financed by institutional investors outside the stock exchanges appear to be doing the same.

Strategizing

To some extent firms can influence regulation complexity by rent seeking. While regulators (politicians and bureaucrats) may benefit from complexity for example to extract favors, companies as a group should have a clear direct interest in lower complexity and deregulation. However, it is not self- evident that rent seekers will always lobby for low complexity. Since companies differ in terms of their ability to handle administrative complexity (for example large firms have more resources than small firms), it seems possible that some large firms can benefit relatively speaking from more complex regulation. This applies particularly to rules and regulations which are already in effect. Moreover, advisors will generally have a vested interest in more complex regulation which means more business for them. While lobbying for greater regulation complexity may be privately optimal, it is clearly very costly to society.

In summary, there are large costs of regulation complexity. Firms may react to these costs in various ways, but none of these are free. In addition to the (costly) obedient compliance presumably desired by regulators, firms can adopt a range of other (undesired) strategies like exit and relocation, rent seeking and noncompliance.


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Corporate Governance and Business Ethics Topics