2.3  Why regulations fail - incentives on regulators

Regulatory failure can include a situation as wide as when Government intervention fails to achieve its objective, or more narrowly, a situation where the outcome after intervention is worse than it was expected to be without the intervention. The discussion here focuses on the latter type of failure. That failure can be due to fundamental flaws in regulatory policies, such as information gaps, or prescribed to the shortfalls of bureaucracy[5] (see Table 2).

Regulatory failure can arise from the same source as market failure; eg, a cross-border externality may not be reflected in national regulation, or regulation may be designed to capitalise on the externality at the expense of other countries (Neven, 1992). Some of these factors may need to be recognised and taken into account, such as lack of capability to regulate which can drive towards either no regulation or resort to an external regulatory framework. Others, such as flexibility, objectives and interdependence can be identified and addressed in regulatory design.

Addressing incentives is the most complex aspect of avoiding or explaining regulatory failure. One approach is to use multi-industry regulators which can be more efficient, face reduced information asymmetries (information disclosure regimes can also help here) and be harder for any one industry to dominate.

Principal/agent theory suggests that agents can favour interest groups at the expense of others in exchange for benefits to themselves. The nature of regulation complicates the principal-agent problem “due to an inability to meaningfully measure performance” (Bailey, 2001). There may be a principal/agent problem among ministers, officials and the public in a Westminster style of government (see Table 3), as ministers fill both roles – that of principal with respect to departments and of agent with respect to the public.

Both ministers and officials tend to be held more accountable for failing to regulate than for regulating at excessive cost, as the former is more transparent and can be held up as the reason for any negative outcomes in the activity to be regulated. Excessive regulation, however, is much harder to detect and the costs will be dispersed among those who are regulated, or those to whom the costs can be passed on. This effect skews regulatory decisions and is particularly prominent when dealing with risks that involve a low probability but very high consequences; eg, air safety or biosecurity.

One result, in practice, of these incentives is a public sector that is good at providing solutions which are low risk and have a minimal fiscal impact, but which impose high compliance costs on businesses or individuals. Both ministers and officials face strong incentives to “get something done” and weak incentives to “do it well” or take a longer term perspective (eg, develop improved policy capabilities). The popularisation of concepts such as market failure encourage this approach, while the risk of government or regulatory failure is much harder to explain or is seen as an excuse for inaction.

Regulators are also constrained by the extent to which an issue is the subject of public debate (in general low public awareness gives regulators more discretion although a polarised debate can give regulators complete freedom) or of political commitments.

A number of these causes of failure also arise outside government of course, but “the obvious difference is that failed government policies, until corrected, have the force of law, and affect the prosperity and success of all” (Lochner, 2000:838). This is why so much effort is put into improving regulation.