Archives For behavioral economics

Yale Law Journal has published my article on “The Antitrust/ Consumer Protection Paradox: Two Policies At War With One Another.”  The hat tip to Robert Bork’s classic “Antitrust Paradox” in the title will be apparent to many readers.  The primary purpose of the article is to identify an emerging and serious conflict between antitrust and consumer protection law arising out of a sharp divergence in the economic approaches embedded within antitrust law with its deep attachment to rational choice economics on the one hand, and the new behavioral economics approach of the Consumer Financial Protection Bureau.  This intellectual rift brings with it serious – and detrimental – consumer welfare consequences.  After identifying the causes and consequences of that emerging rift, I explore the economic, legal, and political forces supporting the rift.

Here is the abstract:

The potential complementarities between antitrust and consumer protection law— collectively, “consumer law”—are well known. The rise of the newly established Consumer Financial Protection Bureau (CFPB) portends a deep rift in the intellectual infrastructure of consumer law that threatens the consumer-welfare oriented development of both bodies of law. This Feature describes the emerging paradox that rift has created: a body of consumer law at war with itself. The CFPB’s behavioral approach to consumer protection rejects revealed preference— the core economic link between consumer choice and economic welfare and the fundamental building block of the rational choice approach underlying antitrust law. This Feature analyzes the economic, legal, and political institutions underlying the potential rise of an incoherent consumer law and concludes that, unfortunately, there are several reasons to believe the intellectual rift shaping the development of antitrust and consumer protection will continue for some time.

Go read the whole thing.

The FTC is having a conference in the economics of drip pricing:

Drip pricing is a pricing technique in which firms advertise only part of a product’s price and reveal other charges later as the customer goes through the buying process. The additional charges can be mandatory charges, such as hotel resort fees, or fees for optional upgrades and add-ons. Drip pricing is used by many types of firms, including internet sellers, automobile dealers, financial institutions, and rental car companies.

Economists and marketing academics will be brought together to examine the theoretical motivation for drip pricing and its impact on consumers, empirical studies, and policy issues pertaining to drip pricing. The sessions will address the following questions: Why do firms engage in drip pricing? How does drip pricing affect consumer search? Where does drip pricing occur? When is drip pricing harmful? Are there efficiency justifications for the practice in some situations? Can competition prevent firms from harming consumers through drip pricing? Can consumer experience or firm reputation limit harm from drip pricing? What types of policies could lead to improved consumer decision making and under what circumstances should such policies be applied?

The workshop, which will be free and open to the public, will be held at the FTC’s Conference Center, located at 601 New Jersey Avenue, N.W., Washington, DC. A government-issued photo ID is required for entry. Pre-registration for this workshop is not necessary, but is encouraged, so that we may better plan for the event.

Here is the conference agenda:

8:30 a.m.   Registration
9:00 a.m. Welcome and Opening Remarks
Jon Leibowitz, Chairman, Federal Trade Commission    
9:05 a.m. Overview of Drip Pricing
Mary Sullivan, Federal Trade Commission  
9:15 a.m. Consumer and Competitive Effects of Obscure Pricing
Joseph Farrell, Director, Bureau of Economics, Federal Trade Commission
9:45 a.m.  Theories of Drip Pricing
Chair, Doug Smith, Federal Trade Commission
[Presentation] David Laibson, Harvard University
[Presentation] Michael Baye, Indiana University
[Presentation] Michael Waldman, Cornell University
[Comments] Discussion leader
Michael Salinger, Boston University
11:15 a.m.  Morning Break
11:30 a.m.  Keynote Address
Amelia Fletcher, Chief Economist, Office of Fair Trading, UK
12:00 p.m Lunch
1:00 p.m. Empirical Analysis of Drip Pricing
Chair, Erez Yoeli, Federal Trade Commission
Vicki Morwitz, New York University
Meghan Busse, Northwestern University
Sara Fisher Ellison, Massachusetts Institute of Technology
[Comments] Discussion leader
Jonathan Zinman, Dartmouth College
2:30 p.m. Afternoon Break
2:45 p.m. Public Policy Roundtable
  Moderator, Mary Sullivan, Federal Trade Commission

Michael Baye, Indiana University

Sara Fisher Ellison, Massachusetts Institute of Technology

Rebecca Hamilton, University of Maryland
  David Laibson, Harvard University
  Vicki Morwitz, New York University
  Michael Salinger, Boston University
  Michael Waldman, Cornell University
  Florian Zettelmeyer, Northwestern University
  Jonathan Zinman, Dartmouth College
3:45 p.m.  Closing Remarks

I’ve posted to SSRN an article written for the Antitrust Law Journal symposium on the Neo-Chicago School of Antitrust.  The article is entitled “Abandoning Chicago’s Antitrust Obsession: The Case for Evidence-Based Antitrust,” and focuses upon what I believe to be a central obstacle to the continued evolution of sensible antitrust rules in the courts and agencies: the dramatic proliferation of economic theories which could be used to explain antitrust-relevant business conduct. That proliferation has given rise to a need for a commitment to develop sensible criteria for selecting among these theories; a commitment not present in modern antitrust institutions.  I refer to this as the “model selection problem,” describe how reliance upon shorthand labels and descriptions of the various “Chicago Schools” have distracted from the development of solutions to this problem, and raise a number of promising approaches to embedding a more serious commitment to empirical testing within modern antitrust.

Here is the abstract.

The antitrust community retains something of an inconsistent attitude towards evidence-based antitrust.  Commentators, judges, and scholars remain supportive of evidence-based antitrust, even vocally so; nevertheless, antitrust scholarship and policy discourse continues to press forward advocating the use of one theory over another as applied in a specific case, or one school over another with respect to the class of models that should inform the structure of antitrust’s rules and presumptions, without tethering those questions to an empirical benchmark.  This is a fundamental challenge facing modern antitrust institutions, one that I call the “model selection problem.”  The three goals of this article are to describe the model selection problem, to demonstrate that the intense focus upon so-called schools within the antitrust community has exacerbated the problem, and to offer a modest proposal to help solve the model selection problem.  This proposal has two major components: abandonment of terms like “Chicago School,” “Neo-Chicago School,” and “Post-Chicago School,” and replacement of those terms with a commitment to testing economic theories with economic knowledge and empirical data to support those theories with the best predictive power.  I call this approach “evidence-based antitrust.”  I conclude by discussing several promising approaches to embedding an appreciation for empirical testing more deeply within antitrust institutions.

I would refer interested readers to the work of my colleagues Tim Muris and Bruce Kobayashi (also prepared for the Antitrust L.J. symposium) Chicago, Post-Chicago, and Beyond: Time to Let Go of the 20th Century, which also focuses upon similar themes.

WSJ has an interesting story about the growing number of employer efforts to import “game” like competitions in the workplace to provide incentives for employees to engage in various healthy activities.  Some of these ideas sound in the behavioral economics literature, e.g. choice architecture or otherwise harnessing the power of non-standard preferences with a variety of nudges; others are just straightforward applications of providing incentives to engage in a desired activity.

A growing number of workplace programs are borrowing techniques from digital games in an effort to encourage regular exercise and foster healthy eating habits. The idea is that competitive drive—sparked by online leader boards, peer pressure, digital rewards and real-world prizes—can get people to improve their overall health.

A survey of employers released in March by the consulting firm Towers Watson and the National Business Group on Health found that about 9% expected to use online games in their wellness programs by the end of this year, with another 7% planning to add them in 2013. By the end of next year, 60% said their health initiatives would include online games as well as other types of competitions between business locations or employee groups.

How well do these programs work in practice?  The story reports mixed evidence of the efficacy of the various game-style competitions; this is not too surprising given the complexity of individual incentives within organizations and teams.

Researchers say using videogame-style techniques to motivate people has grounding in psychological studies and behavioral economics. But, they say, the current data backing the effectiveness of workplace “gamification” wellness programs is thin, though companies including WellPoint Inc. and ShapeUp Inc. have early evidence of weight loss and other improvements in some tests.

So far, “there’s not a lot of peer-reviewed evidence that it achieves sustained improvements in health behavior and health outcomes,” says Kevin Volpp, director of the University of Pennsylvania’s Center for Health Incentives and Behavioral Economics.

Moreover, some employees may feel unwanted pressure from colleague-teammates or bosses when workplace competitions become heated, though participation is typically voluntary.

Incentives are powerful; but when and how they matter depends upon institutions.  Gneezy et al have an excellent survey of the literature in the Journal of Economic Perspectives, where they conclude:

When explicit incentives seek to change behavior in areas like education, contributions to public goods, and forming habits, a potential conflict arises between
the direct extrinsic effect of the incentives and how these incentives can crowd out intrinsic motivations in the short run and the long run. In education, such incentives seem to have moderate success when the incentives are well-specifified and well-targeted (“read these books” rather than “read books”), although the jury is still out regarding the long-term success of these incentive programs. In encouraging contributions to public goods, one must be very careful when designing the incentives to prevent adverse changes in social norms, image concerns, or trust. In the emerging literature on the use of incentives for lifestyle changes, large enough incentives clearly work in the short run and even in the middle run, but in the longer run the desired change in habits can again disappear.

HT: Salop.


Fruit trees in a number of cities, including San Francisco, are prevented from bearing fruit in the name of “protecting” pedestrians from slip and falls and keeping away insects and vermin.  In response to these regulations, a group of Guerilla Grafters has emerged to — you guessed it — graft fruit bearing branches onto the non-fruit bearing city trees.

But grafting trees to bear the occasional pear is not all fun and games, apparently.  San Francisco officials consider the renegade arborists to be engaged in a serious offense (San Francisco Examiner):

While the grafters’ activities might seem harmless, Public Works Director Mohammed Nuru said the renegade gardeners are running afoul of the law.

“The trees that are in the right of way, they’re not for grafting,” he said. “The City considers such vandalism a serious offense. There would be fines for damage to city property.”

Nuru had not heard of Guerrilla Grafters, but said he would ask his staff to investigate. Meanwhile, he added, if the grafters have ideas about urban agriculture, they should discuss them with city officials.

NPR embeds one reporter with grafter Tara Hui on a covert grafting operation.  The first thought that crossed my mind as I read the story was skepticism that the costs associated with fallen fruit on city trees could be significant.  The second was hope the story had overestimated the prevalence of this type of regulation.  There is also some interesting law and economics.  The cops and robbers angle in the NPR story with Hui attempting to avoid detection for fear of sanction by the city authorities in the way of fines for vandalism was also interesting.  From the standard Beckerian model of rational criminal behavior we see Hui’s sensitivity to changes in the “price” of engaging in guerilla grafting (that is, the probability of detection weighted by the sanction she will pay if caught) and investments to avoid detection.

But what about the economic benefits?  Here’s Hui’s account:

“If we say where it is, they could come after me,” says Tara Hui, a fruit tree grafter. She’s talking about city officials, who manage the trees and say it’s illegal to have fruit trees on sidewalks.  So let’s just say we’re in some Bay Area city in a working-class neighborhood, at a line of pear trees that bear no pears.

Hui and two assistants pull out a knife, reach into a plastic bag filled with twigs no bigger than your pinkie, and cut from a fruit bearing pear tree. She says it’s an Asian pear, and that she’s grafting it onto a flowering pear tree.  They whittle a wedge into one end of their twig, then cut a groove into a similar-sized twig on the city tree. They join the two, like tongue and groove carpenters. And when their grafted twig eventually grows into a branch.

“There will be a much better looking tree that actually will provide fruit for people that come by,” Hui says.

Hui’s motives to break the law are straightforward.

“We don’t have a supermarket and we have very few produce stores [here],” she says. “What better to alleviate scarcity of healthy produce in an impoverished area than to grow them yourself and to have it available for free.”

For a recent and illuminating paper on the law and economics of criminal behavior which attempts to incorporate conventional critiques of the economic approach — for example, that criminals lack self-control, have non-standard preferences or do not act in their own self-interest — into the standard model, see Murat Mungan’s Law and Economics of Fluctuating Criminal Tendencies.  Mungan’s main goal is to show that the standard economic approach is capable of modification so as to absorb more realistic assumptions and that it gains explanatory power by doing so.

HT goes to Steve Salop for pointing me to the Guerilla Grafter story.

Douglas Ginsburg and I have posted “Free to Err: Behavioral Law and Economics and its Implications for Liberty” on the new and very good Liberty Forum.  Our contribution is based upon a more comprehensive analysis of the implications of behavioral law and economics for both economic welfare and liberty forthcoming in the Northwestern Law Review.   We were fortunate to draw several thoughtful responses to our piece as part of the Forum, and I’ve provided links to those here:

We have have some thoughts to the various responses later, but please do go and read them.

And a reminder to readers interested in the topic more generally that our “Free to Choose” symposium on behavioral law and economics is available here.

Haas-Sloan Conference on 

The Law & Economics of Organization: New Challenges and Directions

Nov. 30-Dec. 1, 2012

The Walter A. Haas School of Business, with support from the Alfred P. Sloan Foundation, is issuing a call for original research papers to be presented at the Conference on The Law & Economics of Organization: New Challenges and Directions. The conference will be held at the Haas School of Business in Berkeley, CA, on Friday, November 30, and Saturday, December 1, 2012. A reception and dinner will follow a keynote address by Nobel Laureate Oliver Williamson on Friday.

The purpose of the conference is to take stock of recent advances in the analysis of economic organization and institutions inspired by the work of 2009 Nobel Laureate Oliver Williamson and to examine its implications for contemporary problems of organization and regulation. Empirical research and research informed by detailed industry and institutional knowledge is especially welcome.

Relevant topics include but are not limited to

  • the nature, role, and implications of bounded rationality and opportunism as they relate to issues of contracting and the institutional framework governing contractual relationships
  • government intervention in the market through regulation, antitrust policies, and direct investment (e.g., energy market and health care regulation; patent enforcement; concession contracts in alternative legal environments; government tax preferences for and subsidization of technologies and markets)
  • the operation and regulation of financial markets and institutions (e.g., the origins of and responses to the financial crisis; the role of credit rating agencies; financial and futures market organization and regulation)
  • legal and economic determinants of corporate organization, from joint ventures to the organization of corporate boards (e.g, labor restrictions and corporate organization; organization of high technology companies; regulation of corporate boards)

Paper proposals or, if available, completed papers should be submitted on line at by March 31, 2012. The deadline for completed papers is November 1, 2012. Selections will be made by the conference organizers, Professors Pablo Spiller (Berkeley), Scott Masten (Michigan), and Alan Schwartz (Yale). Conference papers will be published in a special issue of the Journal of Law, Economics, & Organization.

Tomorrow morning at 10:30 I’ll be on a panel at AALS discussing behavioral economics and antitrust law and policy.

The panel includes: James Cooper, Bruce Kobayashi, William Kovacic, Steve Salop, Maurice Stucke, Avishalom Tor and myself.  Its a really good group and I’m looking forward to the discussion.  Here are the session details:

The program will focus on the influence of Behavioral Economics on Antitrust Law and Policy.  Behavioral economics, which examines how individual and market behavior are affected by deviations from the rationality assumptions underlying conventional economics, has generated significant attention from both academics and policy makers. The program will feature presentations by leading scholars who have addressed how behavioral economics impacts antitrust law and policy.

In my presentation I’ll be discussing my work on the topic (co-authored with Judd Stone) and some extensions of that work.

See you there.

TOTM alumnus Todd Henderson recently pointed me to a short, ten-question interview Time Magazine conducted with Nobel prize-winning economist Daniel Kahneman.  Prof. Kahneman is a founding father of behavioral economics, which rejects the rational choice model of human behavior (i.e., humans are rational self-interest maximizers) in favor of a more complicated model that incorporates a number of systematic irrationalities (e.g., the so-called endowment effect, under which people value items they own more than they’d be willing to pay to acquire those same items if they didn’t own them). 

 I’ve been interested in behavioral economics since I took Cass Sunstein’s “Elements of the Law” course as a first-year law student.  Prof. Sunstein is a leading figure in the “behavioral law and economics” movement, which advocates structuring laws and regulations to account for the various irrationalities purportedly revealed by behavioral economics.  Most famously, behavioral L&E calls for the imposition of default rules that “nudge” humans toward outcomes they’d likely choose but for the irrationalities and myopia with which they are beset.

 I’ve long been somewhat suspicious of the behavioral L&E project.  As I once explained in a short response essay entitled Two Mistakes Behavioralists Make,  I suspect that behavioral L&E types are too quick to reject rational explanations for observed human behavior and that they too hastily advocate a governmental fix for irrational behavior.  Time’s interview with Prof. Kahneman did little to allay those two concerns.

Asked to identify his “favorite experiment that demonstrates our blindness to our own blindness,” Prof. Kahneman responded:

It’s one someone else did.  During [the ’90s] when there was terrorist activity in Thailand, people were asked how much they’d pay for a travel-insurance policy that pays $100,000 in case of death for any reason.  Others were asked how much they’d pay for a policy that pays $100,000 for death in a terrorist act.  And people will pay more for the second, even though it’s less likely.

 This answer pattern is admittedly strange.  Since death from a terrorist attack is, a fortiori, less likely than death from any cause, it makes no sense to pay the same amount for the two insurance policies; the “regardless of cause” life insurance policy should command a far higher price.  So maybe people are wildly irrational in comparing risks and the value of risk mitigation measures.

 Or maybe, as boundedly rational (but not systematically irrational) beings, they just don’t want to waste effort answering silly, hypothetical questions about the maximum amount they’d pay for stuff.  I remember exercises in Prof. Sunstein’s class in which we were split into groups and asked to state either how much we’d pay to obtain a certain object or, assuming we owned the object, how much we’d demand as a sales price.  I distinctly recall thinking how artificial the question was.  Given the low stakes of the exercise, I quickly wrote down some number and returned to thinking about what I would have for lunch, what was going to be on Sunstein’s exam, and whether I had adequately prepared for my next class.  I suspect my classmates did as well.  Was it not fully rational for us to conserve our limited mental resources by giving quick, thoughtless answers to wholly hypothetical, zero-stakes questions?

If so, then there are two possible reasons for subjects’ strange answers to the terrorism insurance questions Kahneman cites:  Subjects could be wildly irrational with respect to risk assessment and the value of protective measures, or they might rationally choose to give hasty answers to silly questions that don’t matter.  What we need is some way to choose between these irrational and rational accounts of the answer pattern.

Perhaps the best thing to do would be to examine people’s revealed preferences by looking at what they actually do when they’re spending money to protect against risk.  If Kahneman’s explanation for subjects’ strange answers were sound, we’d see people paying hefty premiums for terrorism insurance.  Profit-seeking insurance companies, in turn, would scramble to create and market such risk protection, realizing that they could charge irrational consumers far more than their expected liabilities.  But we don’t see this sort of thing.

That suggests that the alternative, “rational” (or at least not systematically irrational) account is the more compelling story:  Subjects pestered with questions about how much hypothetical money they’d spend on hypothetical insurance products decide not to invest too much in the decision and just spit out an answer.  As we all learn as kids, you a ask a silly question, you get a silly answer.

So again we see the behavioralist tendency to discount the rational account too quickly.  But what about the second common behavioralist mistake (i.e., hastily jumping from an observation about human irrationality to the conclusion that a governmental fix is warranted)?  On that issue, consider this portion of the interview:

Time:  You endorse a kind of libertarian paternalism that gives people freedom of choice but frames the choice so they are nudged toward the option that’s better for them.  Are you worried that experts will misuse that?

Kahneman:  What psychology and behavioral economics have shown is that people don’t think very carefully.  They’re influenced by all sorts of superficial things in their decisionmaking, and they procrastinate and don’t read the small print.  You’ve got to create situations so they’ll make better decisions for themselves.

Could Prof. Kahneman have been more evasive?  The question was about an obvious downside of governmental intervention to correct for systematic irrationalities, but Prof. Kahneman, channeling Herman “9-9-9” Cain, just ignored it and repeated his affirmative case.  This is a serious problem for the behavioral L&E crowd:  They think they’re done once they convince you that humans exhibit some irrationalities.  But they’re not.  Just as one may believe in anthropogenic global warming and still oppose efforts to combat it on cost-benefit grounds, one may be skeptical of a nudge strategy even if one believes that humans may, in fact, exhibit some systematic irrationalities.  Individual free choice may have its limits, but governmental decisionmaking (executed by self-serving humans whose own rationality is limited) may amount to a cure that’s worse than the disease.

Readers interested in the promise and limitations of behavioral law and economics should check out TOTM’s all-star Free to Choose Symposium.



Law Review Editors…take note.  You may get an opportunity to catch this one in February if you play your cards right.

I’ve been blogging updates of my research for a new article developing what the economic analysis provisions of the National Securities Markets Improvement Act of 1996 requires of new SEC rulemaking.  Blog colleague Prof. Wright has a great title suggestion: “The Law and Economics Revolution in Securities Law.”  I like it.  I would add: “Constructing the Four Pillars.”

This project is inspired by the DC Circuit’s opinion in Business Roundtable v. SEC, which revives the four principles in a tremendous way, and the project forms the heart of my research plan as a fellow at the Hoover Institution this semester studying economic analysis of law and my syllabus for a seminar in the law and economics of financial regulation I am teaching at Stanford Law School this semester.  Prior posts are referenced here.

In prior posts I described the first portion of this article, which will use legislative and judicial history to elaborate on the SEC’s mandate to consider the impact of new rules on what I am calling the “four pillars” or “four principles” of securities regulation:  investor protection, efficiency, competition, and capital formation.  The second portion of the article will seek to link the various relevant literatures to prospective rulemaking.

The second portion of the article will start with a broad view of various strains of the economic literature and move to a more particular focus on individual articles.  Along the way I’ll be calling balls and strikes for the relevance of entire strains of the securities regulation, economics, and financial economics literature generally, and individual articles in particular.  I will do so using the hurdles presented by the legislative and judicial history of the NSMIA that, like Prometheus stealing flame from Olympus, brought us the four principles as a light by which to interpret the means and ends of securities regulation more clearly.

This article will be controversial (at least I hope).

The legislative and judicial history from the first half of this article will describe a lot of nuance, but the dominant theme taking shape is that the drafters of the NSMIA were inspired by the benefits of cost-benefit analysis (CBA) and economic analysis as a guiding principle in securities regulation.  The legislation was largely authored by Congressman Jack Fields who was appointed to chair the subcommittee overseeing the securities laws.  The law was promulgated pursuant to the Contract With America.  On the Senate side the legislation was sponsored by Senator Phil Gramm.  The legislative history, as described in a prior post, clearly envisioned in part some version of the regulatory analysis conducted by the SBA for small businesses and by the White House Office of Management and Budget (OMB) Office of Information and Regulatory Affairs (OIRA) more generally.  In the three judicial cases interpreting the NSMIA (all of which ruled against the SEC) the court demonstrated a premier focus on the empirical economic literature as well as a focus on indirect costs.  The four principles take cost-benefit analysis to a new level by considering impact on institutional incentives, capital market efficiency, and competition.

Logistical problems that should be considered:

1) What is the significance of what I would call the patchwork problem?  So many SEC regulations reference other regulations, and presume the existence of a number of other levers in the system of SEC regulation, and in some rule proposals also assume the existence of regulatory regimes administered by other agencies.  Must new regulations be measured against the alternative of not only the status quo, but of actually amending or eliminating prior regulations?

2) What about looking back?  Is a sunset requirement in SEC regulations generally, or in some specific areas, advisable?  Does it speak toward a heightened scrutiny from the DC Circuit for regulations that do not have a sunset requirement?  Does it require the SEC conduct a CBA at some point (5 or 10 years) after the rule is adopted?  What are the corresponding uncertainty or transition costs associated with firm compliance flowing from such a requirement?

3) What about the issue of potential implicit NSMIA repeal as Congress issues mandates that would otherwise fail a proper cost-benefit analysis?  The SEC has taken the position that it is not required to perform CBA where Congress explicitly mandates that it promulgate a rule.  But the SEC certainly has discretion at multiple decision points in adopting a rule.  Consider all the discretionary decisions that must be made by the SEC staff as they write a multi-hundred page rule proposal implementing a rule required by a paragraph long amendment in the authorizing legislation.  Shouldn’t the SEC be held to a requirement that it meet CBA requirements whenever it actually exercises discretion?  Conversely, if the SEC’s position is that Congress implicitly pre-empted the NSMIA with an affirmative requirement to adopt a rule, shouldn’t the SEC be required during judicial review to demonstrate that position by showing that there is no way to implement the rule in a way that would survive review under the four pillars of the NSMIA?

4) Position consistency is a principle that must be part of this calculus.  Should the SEC be allowed to take mutually inconsistent positions in different rules?  Note that the SEC cited a couple of studies in the final draft of Reg FD (which inhibited selective provision of information to analysts and required industry-wide announcements if any information is publicly provided) arguing that issuers had plenty of incentive, in spite of Reg FD, to share information with the market to facilitate new offerings and to maintain long term customer and supplier relationships.  That position directly contradicts the agency’s position in a number of other rules mandating affirmative disclosure of various items.  How does this play into judicial review for agency consideration of the four principles?

Thoughts taking shape about the various economic literatures:

A) Public Choice/Public Finance Economics—–I am not aware of a single instance where Henry Manne or Jon Macey’s work in the public choice problems of securities regulation have ever been cited in the cost-benefit analysis section of an SEC rule.  The Commission should be held to some consideration of the effect of new rules on this problem.  New rules alter the relationships between market participants in ways that accrue rents to I-bankers, lawyers, and accountants, particularly those with prior SEC experience.  I see no reason why this impact shouldn’t be relevant.  Deadweight losses are quite costly when rules are adopted.  With respect to analysis post-rule, one would need to ask to what extent rent seeking effects are dynamic, and to what extent they are static and thus capitalized into stock price as of the rule’s adoption.

B) Austrian Economics—–I think Austrian thought will be most useful in this project in offering some broad insights for regulatory architecture.  For instance, the role of the entrepreneur in discovering information and the pervasive uncertainty of the future demonstrated by the Austrian literature seem to argue against the SEC’s obsessive focus on uniformity.  This is true in accounting rules, in market structure, in the broker fiduciary duty debate, in mandatory private equity and hedge fund registration, and in the “dark pool” controversy.  There seems to be a marked hesitation at the SEC for diverse paths that develop for forming capital or institutions that develop idiosyncratic methods for valuing assets, structuring their board, deploying capital, etc.  This literature’s influence will be subtle, it won’t help to measure a compliance cost dollar figure for instance, but I think I can certainly incorporate the literature in a broad way to inform how the regulatory adoption process must be structured.  Reading Rizzo and Kirzner on the economics of time and information, I am convinced of the necessity to require that SEC rules be considered not only at the point of adoption, but that they must also be subject to an economic analysis requirement post-implementation.

C) Behavioral Economics—–Given the disclosure-based system, and the fraud on the market presumption, and the use of event studies in determining damages, the legislative history and judicial interpretations of the ’33, ’34 and ’40 Acts seem to presume semi-strong market rationality.  I think the four principles must be read in light of that presumption.  Thus behavioral economics has little relevance for new SEC rule-making with respect to arguments about the rationality of investors.  If we look to rationality arguments with respect to the biases of regulated actors, like directors or managers, in the vein of Don Langevoort’s work (see e.g. here), there are relevant issues to consider.  Although, once that door is opened, you also have to consider the behavioral biases exhibited by regulators along the lines of Professor, and current SEC Commissioner, Troy Paredes’ work here.

D) Financial/Empirical Economics—–The DC Circuit has demonstrated a particular focus for this type of work to demonstrate either the cost or the benefit side of the equation.  What types of studies count?  In corporate governance many writers have used event studies, but for the purpose of considering new rules event studies require an unanticipated event which will rarely be true for new rule proposals unless significant elements of the rule are unanticipated.  Most of the corporate governance empirical literature has also tried to compare different governance characteristics across firms to make a case for which governance methods should become mandatory, but that type of inquiry often suffers from quite severe endogeneity problems.

The real interesting question is what variables matter and which don’t, because I can see a potential for gamesmanship in selecting the variables impacted based on the what a writer wanted to accomplish.  SEC rules have at times cited to studies looking at impact on abnormal stock price returns, the bid-ask spread, Tobin’s q, trading volume, trading volatility, and brokerage costs, among a variety of other variables.  But how does one choose between these variables as superior indicators of the two “pillars” of efficiency and capital formation?  And what about considering a new SEC rule’s impact on bond yields or on the price of derivatives linked to common equity?  Surely the “capital formation” pillar should include the impact of a new rule on debt and derivatives instruments as well as equity?  What about impacts of rules on the debt/equity tradeoff?  The Miller/Modigliano Theorem of financing irrelevance envisions taxes and bankruptcy as primarily driving the debt/equity financing tradeoff, but shouldn’t we also consider the impact of mandatory disclosure on securities class action risk as well (in other words, the more onerous the risk of securities class action risk, the more attractive debt financing becomes)?

E) Direct Compliance Costs—–The SEC has often made use of direct industry compliance costs in its economic analysis of new rules.  This is a particularly limited measure and is frequently underestimated.  Not much in the way of applicable economic literature here, this estimate mostly relies on conflicted best guesses by SEC staff and likely conflicted estimates from industry comment letters.  The ridiculousness of the SEC staff estimates when viewed post-adoption argues in favor of a mandatory look-back requirement for economic analysis.  (When I say ridiculous, I am thinking of the SEC’s estimate in the rule implementing Sarbox Section 404 that implementation costs would average $90,000 per firm.  An SEC study five years later admits it was more like $2 million per firm.)

In a subsequent post, I will consider how to make more use of the transaction cost or New Institutional Economics literature, particularly with respect to rulemaking under the SEC Division of Corporation Finance and Division of Investment Management jurisdictions, as well as how economic game-theory can prove more useful to inform rulemaking in SEC oversight of the exchanges and SROs through the SEC Division of Trading and Markets.

[Cross-posted at PYMNTS.COM]

Richard Cordray’s nomination hearing provided an opportunity to learn something new about the substantive policies of the new Consumer Financial Protection Bureau.  Unfortunately, that opportunity came and went without answering many of the key questions that remain concerning the impact of the CFPB’s enforcement and regulatory agenda on the availability of consumer credit, economic growth, and jobs.

The Consumer Financial Protection Bureau’s critics, including myself, [1] have expressed concerns that the CFPB— through enforcement and regulation—could harm consumers and small businesses by reducing the availability of credit.  The intellectual blueprint for the CFPB is founded on the insight, from behavioral economics, that “[m]any consumers are uninformed and irrational,” that “consumers make systematic mistakes in their choice of credit products,” and that the CFPB should play a central role in determining which and to what extent these products are used. [2] The CFPB’s recent appointment of Sendhil Mullainathan as its Assistant Director for Research confirms its commitment to the behaviorist approach to regulation of consumer credit.  Mullainathan, in work co-authored with Professor Michael S. Barr, provided the intellectual basis for the much debated “plain vanilla” provision in the original legislation and advocated a whole host of new consumer credit regulations ranging from improved disclosures to “harder” forms of paternalism.  The concern, in short, is that the CFPB is hard-wired to take a myopic view of the tried-and-true benefits of consumer credit markets and runs the risk of harming many (and especially the socially and economically disadvantaged groups in the greatest need of access to consumer credit) in the name of protecting the few.

To be sure, there is absolutely no doubt that there are unscrupulous and unsavory characters in lending markets engaging in bad acts ranging from fraud to preying upon vulnerable borrowers.  Nonetheless, it is critical to recognize the positive role that lending markets and the availability of consumer credit has played in the American economy, especially in facilitating entrepreneurial activity and small business growth.  Taking into account these important benefits is fundamental to developing sound consumer credit policy.  I had hoped that the hearings might focus upon Mr. Cordray’s underlying philosophical approach to weighing the costs and benefits of credit regulation and how that balance might be struck at his CFPB.  They did not, instead focusing largely upon another important issue: the precise contours of CFPB authority and oversight.

Currently, the unemployment rate is over 9 percent and all of the available evidence suggests the CFPB’s approach will run a significant risk of overregulation that will reduce the availability of consumer credit to small businesses and thus further depress the economy.  Therefore, getting hard answers concerning how the CFPB views and will account for these risks in its enforcement and regulatory decisions is critical.  Certainly, the nomination hearing offered small hints toward this end.  We learned that under Mr. Cordray’s watch, CFPB enforcement will involve not only lawsuits but also a “more flexible toolbox” that includes “research reports, rulemaking guidance, consumer education and empowerment, and the ability to supervise and examine both large banks and many nonbank institutions.”

The job of protecting consumers in financial products markets—the domain of the new CFPB—extends to all such consumers.  The benefits of healthy markets and competition in consumer credit products has generated tremendous economic benefits to the most disadvantaged as well as to small businesses.  If the CFPB agenda were limited to educating consumers about the costs and benefits of various products and improving disclosures, there would be far less need for concern that it will be a drag on consumers, entrepreneurial activity, and economic growth.  However, the CFPB’s intellectual blueprint suggests a more aggressive and dangerous agenda, and the authority it has been granted renders that agenda feasible.  The CFPB must account for the benefits from lending markets and balance them against its laudable objective of preventing deceptive practices when crafting its enforcement and regulatory agenda.  Unfortunately, after Tuesday’s nomination hearing, the CFPB’s approach to this complex and delicate balance remains an open question.


[1] David S. Evans & Joshua D. Wright, The Effect of the Consumer Financial Protection Agency Act of 2009 on Consumer Credit, 22(3) Loyola Consumer L. Rev. 277 (2010).

[2] Oren Bar-Gill & Elizabeth Warren, Making Credit Safer, 157 U. Pa. L. Rev. 1, 39 (2008).