The Economics of Regulation Complexity - Corporate Governance and Business Ethics

Following Louis Kaplow (1995) the complexity of regulation is defined by the number and difficulty of the distinctions which the rules make. Difficulty is the effort required to understand the rules. Difficulty is magnified by generality of application, ambiguities and inconsistencies. A complex law regulates many different activities in several different ways based on several different criteria. The volume of code may be an indicator, but not necessarily so, since very detailed provisions may actually make it easier for individual decision makers to find out how they are affected (Ehrlich and Posner 1974). The costs of complexity consist of

  • Legislation costs: resources spent on making law (including influence costs);
  • Information acquisition costs: time spent on verification and interpretation of the rule (including expenditure on advisors);
  • Decision costs: resources spent on analysis of the consequences;
  • Private compliance costs (implementation costs);
  • Public compliance costs: costs of enforcement by government agencies and Courts.

In standard neoclassical economics the costs of complexity are simply ignored. Infinitely rational decision makers instantly understand new regulation and adapt efficiently to it. The implicit assumption seems to be that complexity costs are small compared to production costs. This would be the case if the CEO of a large firm had to read a piece of paper and then make marginal adjustments in company operations. Whether it takes 2 or 4 h to read might not be very important compared to the magnitude of the necessary changes (e. g. , closing a factory).

At the other extreme, in evolutionary economics (Nelson and Winter 1982), Complexity costs are implicitly assumed to be so high that economic agents do not make decisions, but adapt to new rules by trial, error and imitation until new, viable routines are found. We can imagine the regulator or the competition closing down firms which do not comply with the new rules, or alternatively that firms randomly suggest changes in behavior, until the regulator approves. Here the adaptation is very costly for complex regulation, because it takes time, and because many errors are necessary to ensure compliance. At the extreme a large number of firms which do not comply will have to go out of business.

An intermediate position is found in transaction cost economics which assumes that human actors are blooded rational (Williamson 2005). Decision making capacity is therefore a scarce resource. It will take time to comply with complex, new legislation. Organizational change will not happen because the CEO writes a memo, it will involve lots of delegation, information loss and incentive problems (Williamson 1985). In earlier versions of transaction costs economics (Williamson 1975) complexity along with uncertainty was considered a key determinant of transaction costs. To the extent that complexity makes agents uncertain about relevant decision parameters the two concepts coincide. Barzel (1982) draws attention to another source of transaction costs: measurement costs, which he attributes primarily to physical product characteristics (for example it is difficult to verify how an orange tastes until after you have peeled it). Verifiability is a parallel in financial contracting (Hart 2001). Measurement costs will increase in the variability of product characteristics. In this language, regulation complexity might be captured by the variability of economic consequences for the individual firms as well as ambiguity with regard to interpretation and enforcement.

Following this approach, one would imagine that the complexity of regulation would be a function of complexity of goals. For example, legislation based on compromise between several political parties might be more complex or even inconsistent. The same will be the case if there are many bureaucratic offices involved in the genesis and enforcement of a law (for example federal and state organizations as well as judges who may disagree about interpretation). Regulation complexity may also be enhanced by rent seeking (Schuck 1992). Politicians, bureaucrats, lawyers and auditors will often benefit from more detailed regulation which can increase their revenue and social importance.

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