Costly regulatory institutions of enforcement, extent of the market, and rational expectations
49 Pages Posted: 23 Jan 2020 Last revised: 23 Jun 2021
Date Written: May 17, 2020
This paper develops a theory in which public enforcement of financial reporting depends on regulatory institutions that exhibit economy of scale. A more stringent enforcement regime disciplines misreporting, which stimulates investments. However, a government with limited commitment only implements the stringent regime when the market becomes sufficiently large. Although firms collectively have incentives to overinvest to induce excessive public enforcement as a public good, the strategic uncertainty about the others’ investments leads to uncertainty about the future regime. If the reporting environment is not conducive to the expectations of a stringent future regime, the market can instead be undersized and underregulated. Despite a positive cross-sectional association between public enforcement and market size, the markets that feature overenforcement are smaller than those that feature underenforcement. And market size is not a good measure of efficiency to evaluate alternative accounting standards.
Keywords: regulatory enforcement, market development, coordination, higher-order belief
JEL Classification: D78, G38, K22, M41, M48
Suggested Citation: Suggested Citation