Foundations of the Regulatory State, Section 2
Top Student Exam Answers, Spring 2003

Note: These were, in my judgment, the best answers received under examination conditions. They should not be taken as model answers, in that they all contain extraneous material as well as omitting useful information. Some even reach incorrect conclusions. However, they all take intelligent approaches to the questions, are well organized and reasoned, and make sensitive use of the facts. 

• Politically, by addressing not only safety, but also pollution, which is arguably less important to insurers, this proposal will attract the broad coalition of supporters needed to overcome the strenuous objections of other groups.
• Also, standards such as the ones proposed have already been accepted for a large percentage of the vehicles on the road.

Disadvantages

• Libertarians may see this program as infringing on an individual's right to bargain for less safety at a lower cost
• The additional costs that the new requirements will entail will be passed along to consumers, which will disproportionately affect the poor who rely on SUVs
• Owners of older vehicles (again, poor) that are less safe and efficient may be discouraged from purchasing newer vehicles.
• Business leaders will argue that standards will inefficiently apply to many commercial vehicles that arguably do not need to be as safe
• Politically, this program will likely be opposed by labor-unions, auto-manufacturers, and voters in the Midwest, a very valuable electoral region. Politicians who depend on these votes will be unlikely to support such a plan, unless there is a strong coalition on the other side.
• Therefore, while it may be tempting to address only the safety issues, and allow the environmental issues to be handled by arguably more efficient market mechanisms (see below), such plans are not likely to attract a substantive coalition.

Proposal #2: Government Mandate of Additional Insurance for SUVs

The government could mandate additional insurance for SUVs, which would ameliorate insurance companies' fear that introducing additional fees will cause customers to take all of their insurance business elsewhere.

Advantages

• By "eating" losses on SUV accidents, but keeping wealthy customers, insurance companies may be making rational, profit-maximizing decision. As a result, however, drivers of SUVs are not experiencing the full cost of their activity and engage in it too much.
• This is a form of Moral Hazard, where the insured engage in risky behavior with the knowledge that they are protected from the results.
• This would be a very direct and effective plan. Insurers could then calculate the actual market-cost of insuring SUVs and price it into their policy.

Disadvantages 

• This type of legislation would be seen as catering to special interests and would not be likely to gamer much outside support.
• Additionally, this issue may be best handled by the market. If some insurers charged a higher premium for SUVs, the ones that did not would experience adverse-selection from clients who wanted to engage in the risk of driving an SUV without paying any more. It seems that eventually, the market would react and reach equilibrium, without regulation.

Proposal #3: Imposition of Fuel Tax

Advantages

• Market forces will encourage manufacturers to lower emissions in an efficient manner. This will principally affect environmental issues, however, which aren't insurers' primary concern.
• However, it seems likely that one of the principal avenues for increasing fuel efficiency will be to decrease vehicle size, which will increase safety.
• Additionally, the higher price of fuel will reduce the demand for SUVs, which will make them less prevalent on the roads
• Unlike the above proposal, there will be much less need for "sketchy" CBA and fewer administrative costs, such as enforcement and testing.

Disadvantages

• Safety improvements, including size decreases, are by no means a given as they are in the command-and-control plan. Safety-related externalities may not be addressed.
• Distributionally, such a plan will unfairly punish those who already own SUVs.
• Again, libertarian and communitarian concerns militate against allowing individuals to purchase the "right" to endanger others on the road.
  
   

Question 1, Answer 2

AII TALKING POINTS FOR SUV SAFETY REGULATION

• Primary goal is reducing costs related to greater dangerousness of SUVs. This can be achieved by:
  • Reducing the dangerousness of SUVs.
  • Reducing the number of our clients driving SUVs.
• These means can be achieved by lobbying for regulatory changes or by action within the insurance market.

REGULATORY ACTION

• Regulatory action favorable to AII members includes anything that reduces the dangers of SUV driving or reduces the number of SUVs driven, including:
  • Increasing safety requirements for SUVs, either directly (e.g. by requiring side airbags or rigid rollover bars) or by re-designating them as cars instead of light trucks.
  • Raising the cost of SUV ownership by taxing SUVs, giving tax breaks to drivers of safer vehicles, raising the taxes on gasoline, or imposing stricter gas mileage limits for SUVs.
• Any regulation will face significant opposition.
  • SUVs are very popular; consumers will oppose anything that increases their cost.
  • American social mores create very strong resistance to any restriction on driving or on choice of vehicle, and any increase in the cost of driving. Politicians will generally oppose any such measures; the current Republican Congress will likely be especially vehement.
    • SUVs' popularity and Americans' emphasis on individual freedom create a cognitive bias that limits the effectiveness of regulation. Americans will make sacrifices to preserve their driving preferences, so the number of marginal consumers who decide not to purchase SUVs because of increased cost will be smaller than with other commodities.
  • US car companies have a large advantage over foreign companies in SUVs, but not in other vehicles. They will strongly oppose any measure that reduces this advantage by raising the cost of SUVs compared to other vehicles. Unions and politicians from states that depend on the auto industry, such as Michigan, will also oppose.
  • Most SUV owners are relatively wealthy, and therefore wield political power.
  • Regulation that increases the price of SUVs reduces consumer choice, limiting freedom and decreasing the market's efficiency.
  • Changing safety standards will be difficult and expensive. Car companies can be expected to argue and appeal vigorously.
• There are some factors that may create support for regulation.
  • The high safety risk posed by SUVs may lead some legislators to support heightened safety standards.
    • This effect is accentuated by the fact that SUV owners also increase the number and severity of injuries among non-SUV drivers.
  • SUVs get significantly worse gas mileage than cars.
    • Environmental groups will support anything that decreases SUV ownership.
    • Many Americans are increasingly concerned about oil dependence upon other (especially Middle-Eastern) countries, creating some political support for reducing gas consumption.
  • SUV owners are relatively wealthy, so increasing the cost of SUV ownership has a redistributive effect, increasing wealth equality, which will gain support of liberal or populist politicians.
  • Administrative costs for new taxes and enforcing safety standards are not particularly high.

MARKET ACTION

• Currently, SUV owners have no insurance-market incentive to drive safer cars. AII member techniques for combating moral hazard, such as charging deductibles and varying premiums by the driver's safety record, do not impact the insured's choice of car.
• AII members can use various price discrimination techniques to discourage SUV drivership, for example:
  • Charging SUV owners higher premiums or higher deductibles.
  • Varying insurance rates based on the safety features or safety record of individual vehicle models.
  • Providing bonuses for clients switching from an SUV to a safer vehicle.
• Factors against market action:
  • Raising premiums may cause marginal customers who drive SUVs to switch to another insurer, reducing revenue.
    • Most AII members sell several types of insurance; if they raise auto insurance costs, clients may cancel their other policies as well.
  • Raised premiums, especially if industry-wide, will engender political opposition.
• Factors favoring market action:
  • Raising the relative cost of driving SUV swill reduce SUV drivership.
  • The SUV insurance market effectively increases the cost of insuring owners of other vehicles as well, since accidents involving SUVs tend to increase injuries to other car owners as well.
    • This effect reduces AII members' ability to subsidize losses from insuring SUV owners with profits from insuring other car owners.
  • The number of marginal customers who cancel their policies may be relatively small.
    • The same cognitive bias that limits the effectiveness of regulation gives AII members a freer hand to raise premiums. Since American drivers are highly reluctant to give up their SUVs, many who would otherwise cancel their policies may maintain them. The helpfulness of this effect depends on the cost of switching insurers (transaction costs and difference in premiums).
    • Wealthier people tend to place a higher value on safety. Since most SUV drivers are relatively wealthy, they may be less resistant to premium increases that correspond to SUVs' lower safety standards.
  • AII members can mitigate the negative effects of increasing premiums for SUV owners by collaborating to establish new pricing standards
    • Collaboration mitigates effects of adverse selection for insurers that charge lower premiums.
    • Members can avoid antitrust violations by continuing to set actual premiums individually; they need collaborate only to determine what factors should influence premiums.

OTHER OPTIONS

• AII members can discourage SLTV ownership indirectly and cheaply by funding anti-SUV advertising campaigns or supporting anti-SUV groups. Publicity about SUV safety risks and bad gas mileage (cost, environmental effects, and foreign oil dependence) may help to reduce demand.

CONCLUSION

• Tax increases on SUVs or gasoline are almost certainly politically impossible. Gas mileage restrictions are very unlikely to be adopted in the near future. It may be possible to lobby for increased safety requirements for SUVs.
• Some form of price discrimination against SUV owners would be beneficial. Negative market effects can be mitigated by collaboration and political opposition can be mitigated by correlating premiums to safety records or features of vehicle models, rather than targeting SUVs generally.
  
   

• This would allow for more flexibility in the market since corporate agreements are easier to change than government regulations. Further, insurance companies would probably have better information about automobile safety because that is their business.
• However, government regulation is probably favorable because insurance companies have an incentive to break their agreements in order to gain wealthy clients in other forms of insurance (who would go to the providers with the cheapest SUV coverage). Conversely, the government has no such incentive, and indeed has political incentives to keep strict standards (as discussed below).
• Regulation might cause insurance companies to charge SUV owners less for other forms of insurance in order to get around this price control. Consequently, a combination of agreement and regulation is probably best.
• This regulation should probably come federally, rather than from the state level.
• Although states might set more localized standards for insurance rates reflecting their citizens' desires, they might allow for less insurance coverage in order to provide wealthy SUV drivers an incentive to move to that state.
• The federal government has better access to safety information, and is also more capable of setting uniform standards that prevent inconsistencies among the effected nation-wide insurance companies.
• Since SUV drivers will be driving outside their states, they will affect citizens from other states that are not represented by that state's regulations. A uniform national standard would prevent this problem.

Assuming higher insurance rates lead to less SUVs, regulation is politically feasible.

• This regulation would prevent death and injury.
  • While taking away the liberty of people to decide what personal risks they choose to take, the government has a responsibility to other citizens on the roads who did not accept the risk of another person's SUV.
  • This will save society money otherwise lost to medical care and lost employment.
  • Regardless of possible pecuniary costs of regulation, the value of life should not be commodified, and should be saved whenever possible.
  • With new media attention focused on the dangers of SUVs, the voting public will probably support new regulations that create safer roads.
• This can be achieved through a political coalition centered on environmental concerns.
  • The Midwestern communities and unions might form a powerful coalition opposing this regulation due to a real or perceived loss in revenue from SUV sales. However, a coalition of urbanites, environmentalists, and energy-conservers might be able to form a strong counter-force.
    • The urbanites desperately need to lower their ozone levels in order to comply with the Clean Air Act's National Ambient Air Quality Standards. Since SUVs emit high levels of Carbon Dioxide, the gas most associated with global warming, reduction in SUVs would lead to less ozone pollution.
    • Environmentalists, and those concerned with dependence on foreign oil, would prefer less SUVs because they waste gas.
    • Since both urbanites and environmentalists tend to be concentrated in populous states, they are especially politically powerful.
    • Compromise with the Midwest might be possible through tax cuts on domestic sedans, helping to alleviate the car industry's financial losses.
• However, if tariffs on foreign SUVs and/or tax cuts on domestic sedans do not serve to counter the financial loss in domestically manufactured SUVs, then this regulation might be too detrimental, and should not be passed.
  • While perhaps increasing the overall welfare of the more populous urban regions, this regulation could lead to a more serious harm to the basic needs of Midwesterners dependant on this revenue.
  • Yet, it is possible that it would provide these manufacturers an incentive to produce better sedans that can compete with foreign car manufacturers. By thus diversifying their products, it might actually lead to a more stable Midwestern economy that is not dependant on SUV sales.
    
     

• With the exception of the second provision of the CDR proposal, both bills impact the two types of CCAs in the same manner in the sense that the CCAs would ~' uniformly oppose the measures
• The second provision of the CDR proposal however, may have a distributive impact between the two types of CCAs and thus may help to disrupt the potential coalition

Conclusion

The potential coalition formation may work against both bills however the fiduciary problems rampant in the CCA industry counsel in favor of supporting the Blog bill, particularly with the open-ended fourth provision which may be used to appease the CCA coalition. The CDR bill is less justifiable in that it paternalistically prohibits actual transactions and thus should be supported only if it is politically necessary to maintain an alliance with CDR.
 

Question 2, Answer 2

QUESTION 2: Regulation of Credit Counseling Agencies (CCAs) and Bankruptcy Reform

1. CONSIDERATIONS

• The CCA debate highlights tensions between consumer sovereignty and consumer protection.
• Propriety of regulation should be determined by the weight of third-party effects and implications of restricting commercial freedoms.
• Practical considerations impact this calculus. Because self-interested CCAs have little incentive to follow regulations, provisions dependent on voluntary compliance should be eliminated for impracticability.

2. BLOG'S PROPOSAL

Systematic Power Inequalities Demand Regulation:

• Borrowers have little bargaining power to negotiate fair agreements and little money to pursue ex-post litigation against fraudulent CCAs.
• CCAs have incentives to maximize fees received from clients, consolidators, and creditors.
• This asymmetry necessitates intervention.

CCAs Should be Subject to Federal Rather than State Regulation:

• Current dual state and federal jurisdiction preserves diversity of choice among CCA plans.
• However, a "race to the bottom" may lead to concentration of CCAs in states with lax regulation and little consumer protection. This collective action problem militates against state regulation.
• Moreover, bankruptcy reform likely to pass in the Senate puts CCA regulation squarely under federal control.

Blogs Proposal Is Ineffective in Protecting Consumers:

• The information provisions respond to consumers' insufficient knowledge about CCAs' conflicts of interest.
• Incomplete information strongly favors government regulation.
• However, information can accomplish only so much. Consumers have difficulty processing information because of cognitive dissonance.
• Anchoring—yielding a final answer by merely adjusting an initial position—prevents consumers from translating information about CCAs' dual role into appreciation of potential exploitation.
• Excessive confidence convinces consumers that the agency they use is reliable, even if other CCAs are not.
• Absence of past exploitation prevents consumers from recognizing the risk of future harm.
• Self-disclosure by CCAs rather than the government may result in incomplete information:
• CCAs must incur costs generating and analyzing information without receiving benefits in return. They thus have little incentive to provide accurate information.
• CCAs may refuse to comply with disclosure requirements. NFCC noncompliance with the FTC suggests that monitoring is neglected or ineffective. CCAs may ignore Blog's regulations with immunity as well. Punishing fraud is the ideal response, but the FTC has already failed in monitoring fraud.
• Requiring services without charge to clients may hurt consumers.
  • This is a variation of the bankruptcy bill's requirement of free services in the absence of ability to pay, a strong consumer protection.
  • But extending it to services regardless of ability to pay means CCAs will degrade the quality of their services. Requiring free services is the equivalent of imposing a price ceiling. Assuming quality rises with price, capping price at 0 reduces the amount of quality CCAs provide to a minimum, absent external incentives to maintain quality.

3. CDR'S PROPOSAL

Bankruptcy Regulation Protects the Economy:

• Consumers considering bankruptcy are already disproportionately likely to make poor financial decisions (adverse selection); those who view bankruptcy as a safety net lose incentives to take care (moral hazard).
• Bankruptcy affects the entire economy. It is not a private matter between creditor and debtor. This third-party effect calls for government regulation.
• Credit counseling and other requirements reduce the risk that consumers will exploit bankruptcy relief.

Anticipated Justifications for CDR Proposals:

• Defense for offering bankruptcy and part-payment information: Consumers have a right to know their options.
  • Response: Consumer autonomy and preservation of freedom requires that consumers receive information on advantages and disadvantages of bankruptcy and paying creditors in part.
  • The government, not CCAs, should provide educational information.
  • Because bankruptcy and credit defaults have nationwide effects, the government has an interest in providing information on both sides of the decision.
  • Because CCAs have an interest in promoting creditor interests, they cannot provide impartial information.
  • Free information conserves debtors' scarce resources.
• Defense for prohibition on CCAs as sales agents: Government must counteract the principal­-agent problem (CCAs stand to gain from violating obligations to consumers).
  • Response: The prohibition is important for consumer protection. However, CCAs can easily conceal their support of for-profit firms. The provision relies on good-faith compliance.
  • Because enforcement is unfeasible, this provision should be rejected to make the proposed legislation more viable. Legislation solely protecting consumer interests will not survive. Eliminating this restriction does not lose any consumer benefits anyway.
• Defense for credit card prohibition: Government must counteract incentives to offer credit to irresponsible borrowers.
  • CDR is correct that the incentive structure is contrary to borrowers' best interests.
  • However, consumer protection should be sacrificed in this case to liberty interests. Companies should have freedom to seek business with any party they choose.
  • Only in the absence of overwhelming competence or safety concerns (like age restrictions on alcohol and cigarettes) should these freedoms be regulated.

4. ALTERNATIVE PROPOSAL FOR ADDITIONS TO THE BANKRUPTCY BILL

• Instead of spending resources on information, use funding for oversight or mechanisms to prevent unqualified organizations from receiving accreditation.
  • The pending bankruptcy bill institutes government endorsement of CCAs but establishes no funds or procedures to investigate CCAs.
  • Oversight mechanisms may make Blog's provision on providing services without pay viable because CCAs could be trusted to provide quality service.
  • Cost of oversight is justified by the benefit of reduced fraud in the credit market.
• Instead of applying uniform regulations to impede bankruptcy filing across the board, consider the reasons for consumers' financial status.
  • Consumers seeking bankruptcy relief because of uncontrollable factors, such as sudden illness, should not be subject to the same level of scrutiny as consumers seeking relief due to financial negligence.
  • Bankruptcy reform should seek not only to limit fraud and reduce litigation, but also to establish fair procedures that consider the roots of financial difficulties and protect those in the worst positions.
  • Flexibility in regulatory design is costlier, but accounting for differences among bankruptcy seekers tailors regulation to the goal of preventing reliance on bankruptcy by those who can avoid it. But if the goal is to reduce bankruptcy relief overall, uniform rules are best.