Monday, October 17, 2011

Independence and the ratchet effect (by Francesc Trillas)

Last Thursday, I presented at my university a paper on independence and the ratchet effect, co-authored with Joanne Evans, Neil Rickman and Paul Levine. The paper can be found here. In words, the ratchet effect is the tendency of evaluators to "penalize" efficient behaviour by setting higher standards for future evaluations. In the relationship between a regulator and a firm, if a firm is efficient, the regulator may demand more effort in future periods. Anticipating this, the firm may be tempted not to behave as efficiently as it could in the first place. This could be alleviated if the regulator could commit not to "penalize" the firm. One way that this could be done would be to delegate into a type of regulator that is not bothered about the firm enjoying efficiency rents. Of course, the solution implies that the political system is able to commit to respecting the independence of this regulator, something that many countries have found difficult to do. If committing to the institution is possible, then governments should find a regulator with exactly the "right" preferences. This is because a regulator could be too pro-firm, and then allow regulated firms to enjoy too high rents from a social welfare point of view. An interesting result of the paper, although it is established by simulations and not analytically, is that pro-firm (conservative) governments have more to gain from delegation than pro-consumer egalitarian governments, because the latter will resent more the relatively high rents enjoyed by firms. And the paper further discusses the recent never ending "independence debate".

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