Chapter 13

TWO THEORIES OF REGULATION

1. The Public Interest Theory

• This theory suggests that regulation is a response to public demand for correction of
market failure
• The Regulator is the main actor
• Regulator is assumed to have the best interests of society at heart
• It does its best to maximize social welfare and to attain a first best amount of information
production
• Problem: It is very complex task of deciding on the right amount of regulation, lies in the
motivation of the regulator, and it is more difficult than monitoring the manager

2. The Interest Group Theory

• Intorduced into economics by Stiglet (1971). Subsequently , Posner (1974), Peltzman
(1983) And Backer (1983)
• It’s all about competing for and against regulation
• It is also about lobby. Constituencies may also looby against regulation.For example, firms
may lobby against price controls if customers are lobbying for them, and managers may
lobby against new accounting standards
• There are bargaining cost
• Which Interest group will get what it wants? Requires organization and expenditure
• In our context, the interest group theory makes several predictions:
a. Creation of standard setting bodies. A a result, investors would support creation of
standard setting bodies, with representatives thereon to act on their behalf
b. Activities subject to market failure are more likely to be regulated, due to demand from
groups adversely affected
c. Due Process. We expect the management to be involved in standards development
through ex: exposure drafts and board representation

3. Which Theory of Regulation Applies to Standard Setting

• Public Interest theory is difficult to implement and we simply do not know how to calculate
the best tradeoff between the conflicting uses of information
• The interest group theory of regulation it is a better predictor of new standards than the
public interest theory because recognizes the existence of conflicting constituencies

4. Conflict And Compromise

We describe IAS 39 “Financial Instruments: Recognition and Measurement.” Recall that it
proposed fair value accounting for major classes of financial instruments. Since Financial
Institutions are heavy users of financial instruments and are crucial to the operation of the
economy, the views of this important constituency can not be ignored. November 2001 the
 European Bank issued a comment with 4 general concerns which are Short Run and Long Run,
Reliability of Fair value for bank loans, Own Credit Risk, Conservatism

4. Distribution of The Benefits of Information

How is distribution decided
• Individual utilities cannot in general be aggregated into a social preference ordering
• We cannot know if the utility gain of the individual who receives an increase in wealth is
greater than the utility loss of the individual who suffers a decrease in wealth

5. Regulation FD
• Prohibits companies from selectively disclosing information
• Arose from a concern that “big guys” may have more resources
• Big guys may have enough bargaining power to receive privileged inside information
directly from management
• One prediction was that abnormal share returns between earnings announcement dates would
become more volatile
• Volatility of share returns is a measure of new information coming to the market
• More volatility between earnings announcements implies that the market receives more
information sooner

6. Criteria For Standard Setting

• Decision Usefulness
a. Informative future firm performance
Empirical evidence that security prices respond to accounting information suggests that
investors find accounting information useful.
b. How Useful?
the theory of rational investor decision making can be used to predict decision usefulness.
c. Cons
Because of certain public good characteristics of accounting information, we cannot be
sure that the standard that has the greatest decision usefulness is best for society. Since
investors do not directly pay for accounting information, they may “overuse” it.

• Reduction of Information Asymmetry

• The Cause
Market forces operate to motivate management and investors to generate information.
Unfortunately, mar-ket forces alone cannot ensure that the right amount of information
is produced.
• How Standard Reduce Information Asymmetry
Fair Distribution Information toward all investor
• Cons
Hard to know whether this is cost effective