Costly regulatory institutions of enforcement, extent of the market, and rational expectations

49 Pages Posted: 23 Jan 2020 Last revised: 23 Jun 2021

See all articles by Wenjie Xue

Wenjie Xue

Cornerstone Research, Inc.

Date Written: May 17, 2020

Abstract

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

Xue, Wenjie, Costly regulatory institutions of enforcement, extent of the market, and rational expectations (May 17, 2020). Available at SSRN: https://ssrn.com/abstract=3518283 or http://dx.doi.org/10.2139/ssrn.3518283

Wenjie Xue (Contact Author)

Cornerstone Research, Inc. ( email )

1000 El Camino Real
Menlo Park, CA 94025-4327
United States

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