Exam feedback memo, Spring 2003

Date: July 21, 2003
To: Foundations of the Regulatory State students
From: Avery Katz
Re: Feedback on Spring 2003 exam

This memo sets out what I considered to be the main issues raised by our Spring 2003 RegState exam. The memo was composed after I read your exam papers, and so incorporates many of the points that you came up with in writing the exam, as well as those I had identified in advance. Thus, it goes beyond what I expected any individual student to produce on his or her exam paper.

As on the practice memo assignments, the goal of the exam was for you to apply the concepts and ideas we studied in class to the particular policy issues raised by the individual problems. Thus the key to a strong performance was finding the appropriate balance between the general and the specific. Similarly, the exam questions all were based on issues that were analogous to, but in some ways different from, the topics we discussed in class, so a good answer would have paid attention to both the similarities and the differences. Furthermore, as I indicated in my comments on exam preparation, a good answer should take counterarguments seriously, and should make sure to distinguish between stronger and weaker arguments and between more and less important issues.

One comment on style: many of you chose to write your exam essays in the bullet-point format that was requested on the second and third memo assignments. For most of you, this was an effective way to make a sequence of points clearly and concisely; and as a general matter the bullet-point essays were more successful in conveying content than the essays that were in straight prose. A number of bullet-point essays, were overly superficial or conclusory, or used jargon to flag concepts and ideas without explaining clearly the relevance of those ideas to the problem at hand. When using bullet-point, accordingly, it is important to be thorough in substance, even while you are being concise in expression.

Also available on the website are the top student answers to each of the questions to the exam. What made these answers the best was their coverage of arguments, detail and sophistication in their use of facts and in seeing both sides of the issues, clarity in organization and explanation, and the way they demonstrated mastery of concepts from the course. If you drew different inferences from the given facts than the top answers did or chose to discuss different issues, you wouldn't have lost points, unless your inferences were unreasonable or your choice of issues inappropriate.

Your individual exams are available for inspection at the office of my assistant, Joseph McGrath (500/9 JG, 4-3268, [email protected]). I did not make many written comments on the exams themselves; instead, I used a system of symbols to indicate my reaction to particular arguments and inferences. A key to these symbols is attached. I also kept a score sheet containing my own notes on each exam. If you want to discuss your individual exam, please feel free to contact me. You will find it useful, however, to read this model answer as well as the top answers before we meet.

It was a pleasure teaching the class, and I wish you all well. Please keep in touch.

This question assigned you to the role of a policy researcher for the American Insurance Institute (AII), and asked you to write a memorandum setting forth talking points on SUV safety issues to be presented at an upcoming conference on public policy toward SUV's. Although you were given general background on the SUV problem from other perspectives, you were specifically instructed to focus on the particular interests of your insurance clients, and not to expound on regulatory issues generally. Thus, I gave relatively little credit for discussions of non-safety issues such as environmental polllution, except to the extent that you analyzed how the environmental effect of various proposals would influence those proposals' political feasibility or AII's ability to enter into a political coalition with other interest groups. Spending excessive time on such material was the most common reason for lost credit.

A useful place to start, accordingly, is with the interests of your client. The AII is interested in reducing accident costs in order to reduce their claims payouts. They would also be interested in reducing other social costs of SUV's, to the extent that those costs are covered by their insurance policies. AII members who sell health insurance, for instance, would care about environmental pollution to the extent it led to increased health care costs; while AII member who sell only auto insurance would not. In addition, AII members are interested in maintaining their customer base; they would not favor a regulatory policy that would cause their customers to stop buying insurance or to obtain insurance elsewhere (say, through a government program). They might not object to regulations that reduced SUV use, however, so long as they can continue to sell insurance on other activities, such as automobile use that replaces SUV use.

It is also helpful to clarify the nature and main causes of the SUV safety problem before making policy recommendations. In this regard, it is important to distinguish between first-party injuries caused by unsafe or excessive use of SUV's (i.e., injuries suffered by SUV drivers), and third-party injuries (i.e., injuries imposed on pedestrians and other drivers). The problem of first-party injuries might be addressable by the insurance companies themselves, by raising insurance rates or changing insurance classifications, or by information-based policies that better conveyed the risk of SUV's to their drivers. Third-party problems are pure externalities and likely not addressable by such means. Indeed, to the extent that SUV drivers insured by one insurance company impose accident or health losses on the customers of other insurance companies, the companies face a common-pool externality or prisoners' dilemma. No individual insurer has sufficient incentive to charge its customers with the full social costs of their behavior, since most of those costs are externalized to other companies.

We are told, however, that there are also significant problems from a first-party viewpoint, since drivers may be incompletely informed about the consequence of their decision to buy or drive SUV's. This may be due to misinformation promulgated by the SUV producers, or to psychological heuristics that lead people to underestimate the risk of SUV ownership and use. Additionally, demand for SUV's may be influenced by preference-shaping advertising, or other mechanisms of social construction. Thus there may be grounds for some sort of regulation on informational, paternalist, or communitarian grounds.

There are also some special features of the insurance market in particular that exacerbate the problem of SUV overuse. We are told that the insurance premiums currently charged for SUV's do not cover the expected claim costs associated with those SUV's. Strictly speaking, this is not a case of adverse selection, since the insurers know very well which of their customers own SUV's and which do not, and may even have reliable ways to measure mileage traveled (although admittedly, not the degree of care exercised while driving.) Rather, the problem is that the SUV drivers are lucrative customers because of the other business they provide, so that insurers find it in their interest to underprice SUV insurance, subsidizing the excess costs on other lines of insurance and on other non-SUV customers. The underpricing of insurance encourages excess use of SUV's and probably inadequate care while using them as well; this is an instance of moral hazard to the extent it occurs.

It is worth asking why the AII does not handle the problem on its own – i.e., by agreeing among its membership to undertake consumer educational efforts or to raise their rates for SUV drivers. It is not in any individual insurance company's interest to do this alone, of course, but it would be their collective interest. One reason, of course, is that any attempt to set rate jointly would risk running afoul of the antitrust laws, so that at least some government imprimatur would be necessary to implement such a solution. But even apart from antitrust concerns, it would be difficult to maintain and enforce such an arrangement, since the prisoners' dilemma aspect of the problem would remain. It would still be in the interest of individual insurers to cheat on AII guidelines in order to attract a larger share of the desirable SUV customers, because most of the costs of doing so would remain external costs from the viewpoint of individual companies. Such externalities could be internalized through a system of appropriate bribes and side payments among insurers (cf. the Coase theorem), but the transaction costs of maintaining such a scheme would be high. Thus it is necessary to consider state-imposed regulatory solutions.

Here there were several possible regulatory strategies you might have discussed, including:(1) Reclassifying SUV's as ordinary automobiles, and thus subjecting them to the regulatory requirements applicable to automobiles; (2) Raising regulatory requirements for trucks as well as SUV's; (3) Creating a new set of regulations applicable to SUV's alone; (4) Imposing increased tort liability on SUV drivers involved in accidents; (5) Imposing excise taxes on SUV's or on fuel used by SUV's; (6) Requiring SUV manufacturers to make more extensive disclosures of SUV risk; (7) Providing government-supplied consumer information or counter-advertising on SUV risk.

Plainly, you did not have enough space to discuss all these strategies, but a complete answer would have at least raised and discussed the following issues:

Finally, since your assignment was situated in the context of political lobbying, you should have discussed (or at least referred to) issues relating to the political implementation of any proposals you discussed. Your discussion, accordingly, should have incorporated some analysis of the political feasibility of the proposals you discussed, the possible political coalitions you might have entered into, or the possible strategies you might follow to head off political opposition. If you chose todiscuss issues such as environmentalism or energy independence, this was the place. It was also the place to apply ideas from our discussions of political economy and the legislative process: e.g., the relative power of concentrated versus dispersed interests, the role of local interests in assembling a national majority, etc.

A number of you devoted significant space to a discussion of federalism issues (perhaps because of the prominence of those issues in the last memo assignment and in our later class discussions.) I would not have expected federalism issues to loom particularly large in the SUV area (precisely because there is a national market for vehicles and most other auto regulation is already federal) and was a bit surprised at the number of students who chose to allocate their limited space this way, but I did give credit to such discussions as far as they went, to the extent that they did not crowd out discussion of the more important issues identified above.

Here your assigned client was a legislator charged with a decision whether to support or oppose a given bill. Thus in contrast to the first problem, it was important to focus on the specifics of the proposals offered to you. As on the memo assignments, focusing largely on the arguments for a given political position, whether pro-consumer or laissez-faire, was less effective than providing a balanced analysis of advantages and disadvantages before making a recommendation. (The characterization of the Senator as a political centrist was intended to remind you of the need for such analytical balance; some students, however, interpreted centrism as entailing splitting the difference between political positions without regard to their policy merit. While there was room in the question for offering naked political advice of this sort, in general, answers that addressed policy analysis as well as raw political interest were more successful and persuasive.)

As on the first question, it is useful to start with the basic policy justifications for regulating in this area, in order to evaluate how the two pending bills address these justifications. (You could also have chosen to organize your answer differently, discussing these basic justifications in the context of the specific bills, but you should have at least discussed basic justifications before drawing any conclusions or making recommendations.)

These three justifications provide straightforward analogies to the standard arguments for regulating in the health care area. In addition, some of the more basic regulatory justifications we have discussed through the term are also applicable here. These include:

It is also necessary to identify the main political constraints on policymaking in this area before offering advice. Creditor interests have clout (as evidenced by their success in putting forward a bankruptcy bill, and by what you are told about your boss's ties to them), but are not monolithic. Creditors of course would like the government to assist them in obtaining repayment of the loans they extend, other things being equal, and would like credit counselors to do the same. As a general matter, credit counseling agencies (CCA's) would prefer to conduct their business without the constraint of regulation, and would prefer the freedom to collect revenues thru whatever methods are most efficient and lucrative, including referral fees, the sale of related financial services, or even kickbacks from lenders. But we are told that there is a potential division of interest between the relatively establishment creditors who belong to the National Foundation for Credit Counseling (NFCC), and the new and more aggressive creditors who may be responsible for the bulk of recent abuses. The NFCC and its members may favor regulation as a way of hindering competition from newcomers, or more benignly, as a way of protecting their business goodwill and reputation from being undermined by unscrupulous operators whom consumers cannot distinguish from reputable lenders.

Similarly, creditor interests are not entirely opposed to those of debtors, because their profits turn on their ability to market loans; and if credit becomes too unattractive to debtors, creditor revenues will fall. Similarly, if regulation imposes significant new costs on creditors or counseling agencies, it is likely that some of these costs will be passed along to debtors through the terms of credit and counseling contracts. (It's useful to distinguish in this regard, however, between existing debtors, who have already entered into contracts of given terms, and future debtors, who are in theory free to reject credit or insist on compensating terms if collection law shifts against them). Additionally, as indicated above, consumer borrowers and reputable lenders share an interest in regulating abusive competitive tactics by less reputable lenders. And finally, creditor interests coincide with those of at least some debtors on the issue of screening for risk. Low-risk debtors benefit from enhanced screening, which addresses the adverse selection problem and reduces the extent to which low-risk debtors subsidize high-risk ones.

It's likely that creditor interests are better organized than debtor interests, and that older, more establishment creditor interests are bettter organized than the newcomers. But it also appears that consumer interests have at least some political influence, especially with your boss, and so crafting a policy that addresses the core needs of both groups (or at least of critical members of both groups) is essential to passing and implementing any regulatory solution in this area.

We are now in a position to consider the individual bills that are on the legislative agenda, beginning first with the bill proposed by Senator Blog. The various disclosure obligations imposed by the Blog bill would, if effective, address the problems of imperfect information and conflict of interest discussed above. There is no guarantee, however, that consumers would understand the required disclosures or make effective use of them. While it would be relatively inexpensive to ensure that creditors formally issued the disclosures to consumers, ensuring that they did so in a way designed to maximize consumer understanding could be more difficult. Additionally, disclosure-based regulation would not address the issue of bounded rationality (e.g., if for emotional reasons debtors gave excessive weight to advice received from credit counselors, disclosure of objective facts would not solve the problem. )

To the extent that disclosure of potential conflict of interest between debtors and credit counselors has an effect, creditors would obtain less benefit from CCA's, and would likely reduce their contributions to CCA's (reinforcing the historical trend described in the background material provided to you.) They might react by adjusting other terms of the credit contract, for instance by increasing interest rates or engaging in additional screening to avoid lending to higher-risk debtors. Whether they choose the former or the latter adjustment makes a significant difference in judging the benefits of the policy and the political reaction it engenders. An across-the-board increase in interest rates would hurt low-risk debtors who are unlikely to become insolvent or to use credit counselors; an increase in screening would make it harder to high-risk debtors to get credit, but to the extent that we think that those debtors are currently taking on too much risk, such a result may be desirable even if paternalistic.

If the bill were to reduce the amounts paid by creditors to CCA's, the CCA's would also likely have to adjust their practices to make up the lost revenue. They might do so by increasing direct fees to debtors, or increasing the markup on other services they sell. If the CCA's cannot find a way to make up the lost revenue, at least some of them are likely to reduce services. In this last case, it may be necessary for the government to provide some sort of subsidy to credit counselors in order to avoid reduced availability of their services. Whether it is worth providing such a subsidy, in the end, probably turns on whether one thinks that CCA's actually provide valuable financial services to their customers, or instead primarily serve as an enforcement device for creditors ex post.

The Consumers for Debt Relief (CDR) bill offers similar advantages and disadvantages to the Blog bill, with a few important variations. First, the specific mandates it imposes raise the general issue of flexibility versus rigidity in regulation. To wit, rigid regulations tend to be cheaper to enforce and to send a clearer symbolic message if one is required; they are, however, less well tailored to individual circumstances. As a political matter, furthermore, the additional burdens imposed by specific mandates may energize opposition to the proposal and prevent any bill from being passed at all.

Second, the provision barring for-profit CCA's and profits on associated financial services would address the problem of conflict of interest, but would exacerbate the funding problems of CCA's. If CCA's cannot raise their revenue from creditors or from profits on associated services, they will have to charge their customers directly. And it may be in debtors' interests in some cases to purchase credit counseling and other financial services from the same entity, if there are scale or scope economies in providing the services together.

Third, on the issue of limiting credit-card solicitation to potentially or recently insolvent borrowers, the factual record before you is less well developed. It is plausible to conclude that such a regulation would make it more difficult for high-risk debtors from getting credit. Whether this is a desirable result or not, however, depends on a balance of efficiency, distributional, liberty and communitarian concerns. It is possible, for instance, that high-risk credit might in some cases be the only effective way to rescue a failing enterprise.

Finally, it is worth discussing how the above analysis might be affected by the presence on the legislative horizon of bankruptcy legislation that would make it harder for debtors to escape their debtors and that might require debtors to consult CCA's before declaring bankruptcy. On the issue of regulatory justifications, bankruptcy legislation might exacerbate problems of imperfect information and bounded rationality by increasing the severity of consequences resulting from a poor financial decision. On the other hand, it is at least possible that requiring credit counseling will lessen the conflict of interest problem, since a consumer who visits a credit counselor as a result of government mandate is less likely to place unfettered trust in the counselor than one who goes to the counselor on his or her own.

On the issue of political economy, the possibility of logrolling bankruptcy reform with CCA legislation might loosen some of the political constraints discussed above. CCA's might be less inclined to organize against the costs of disclosure or fee regulation if they are simultaneously provided with a substantial increase in business through a counseling mandate in bankruptcy. And creditor interests who would be inclined to complain or reduce contributions to a legislator who supported a pro-consumer CCA bill might be more compliant if the legislator could cite his or her support for a pro-creditor bankruptcy bill. Splitting the difference between creditors and debtors in this way might also be advantageous to your boss in terms of political symbolism.

It was also possible in answering this question to discuss other political issues (e.g., relating to national vs regional issues) and other policy approaches (e.g., rejecting both proposed bills in favor of some other alternative such as enhanced liability for fraud or government-provided credit insurance), and I gave credit for such discussions to the extent that they did not crowd out discussion of the more fundamental issues identified above.

On some exams I also circled particular words or phrases that I found questionable or unclear, or that were misspelled.

	good point or argument
!	excellent point or argument
~	fair point, or incompletely or unclearly expressed
–	weak point
…	point needs elaboration
"	point already made, repetitive, or unnecessarily restating facts
?	unclear
??	very unclear, confused, mixing together separate points
x	mistake of law, misstatement of fact, misuse of term
x?	point appears mistaken
#	irrelevant or tangential point
#?	point's relevance unclear
#cl	point irrelevant to interests of client or to your assigned role
jg	jargon: using technical language as substitute for analysis
ns	non sequitur: conclusion does not follow
ff	fighting facts: contradicting stated facts or making assumptions inconsistent with them
ll	laundry list: throwing in relevant and irrelevant arguments alike, without distinction
lec	lecturing: abstract discussion unconnected to or unnecessary for the problem at hand
ua	unsupported assertion / unidentified assumption
vb	verbose; too much space devoted to the point or points in question
vg	discussion is overly vague
og	discussion is overly general
conc	conclusory; result of argument stated without reasoning
sa	straw argument: weak or caricatured argument set up merely for sake of rebuttal
exag	otherwise good point is overstated or exaggerated
c-a	fails to discuss obvious counterargument
contra	contradiction
ss	slow start: too much space spent restating the issue or getting to the point