Allocating Regulatory Resources

Abstract

This article analyzes how law enforcers (with particular emphasis on securities regulators) should allocate their limited resources among multiple targets, as well as how they are likely to allocate these resources. It modifies existing models in one significant way: it considers the effect of regulation not only on the behavior of those subject to it (potential wrongdoers), but also on the perceptions – and as a result, on the behavior – of those whom regulation seeks to protect (potential victims).

Normatively, the article challenges the view of regulation as a two-way tradeoff between enforcement costs and deterrence of wrongdoing (i.e., the effect of regulation on potential wrongdoers’ risk perception), because it ignores the effect of regulation on potential victims’ risk perception. The article maps a more nuanced tradeoff between regulation’s effects on three key actors: regulators (administrative effects), potential wrongdoers (accountability effects), and potential victims (placebo effects).

Descriptively, the article demonstrates how regulators’ ability to bias arbitrage (create placebo effects for private gain) generates incentives for either under- or over-enforcement, depending on the circumstances. Structural conditions that affect regulators’ incentive to use regulation for bias arbitrage are explored.

Keywords: optimal deterrence, law enforcement, regulation, resource allocation, budgeting, case selection, placebo effect, bias arbitrage

JEL Classification: D73, D78, H40, K14, K22, K23, K42