Too Small to Regulate

Abstract

The paper argues that to achieve compliance of firms with regulations such as product quality or environmental or health standards it is better to have industries with a few large corporations than numerous small firms. We construct a model to show that limited liability constraints bind more easily in competitive industries, making it harder to impose sufficiently severe penalties and costlier to send sufficient monitors. Having large corporations allows the government effectively to delegate some of its monitoring functions to the managers of the corporation. The tradeoff between this issue and the usual argument in favor of competition is considered.

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Notes

  1. 1.

    We are acutely aware, as recent history shows, there are exceptions.

  2. 2.

    For a fascinating account of how this is a concern even in high-income, industrialized countries, see Akerlof and Shiller (2015).

  3. 3.

    Expected utility being cardinal, the theory works just as well with any other level. The important assumption is that the large firm’s punishment is exactly n times that of each small firm. If the large firm can be subjected to even greater punishment, for example by fining away the profits of a conglomerate in other lines of business, our argument will be further strengthened.

  4. 4.

    For this procedure to give a good approximation, we must have \(\theta \,N>>1\). It should not be used when \(\theta \) is small. Of course when \(\theta \approx 0\), the products have independent demands and even a small firm enjoys a monopoly in its own market, so traditional arguments for competition are irrelevant and our argument about regulation costs prevails.

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Acknowledgements

We thank James Matthew Trevino for capable research assistance. Dixit thanks Nuffield Collge, Oxford, where part of his work was done, for its excellent academic facilities and generous hospitality.

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Correspondence to Kaushik Basu.

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Basu, K., Dixit, A. Too Small to Regulate. J. Quant. Econ. 15, 1–14 (2017). https://doi.org/10.1007/s40953-017-0072-9

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Keywords

  • Regulation
  • Firm size
  • Limited liability
  • Corruption
  • Corporation

JEL Classification

  • L10
  • L51