CFA 2 - Econ - Reading 15: Economics of Regulation

4.15.e Maldovia is a rapidly growing emerging market economy. To boost the level of capital per worker, the government allows for higher-than-previously allowed levels of depreciation expense for tax purposes on new equipment lowering the effective cost for the business. This is an example of:

A: a price mechanism regulatory tool. Tax breaks on new equipment purchases are effectively government subsidies. Taxes and subsidies are examples of price mechanism regulatory tool. Regulatory tools include price mechanisms, restrictions on or requirement of certain activities, and provision of public goods or financing of private projects.

4.15.c The requirement for firms to carry out an annual independent audit is best described as a regulation implemented to address:

A: information asymmetry. Management have greater knowledge than investors, a situation known as informational asymmetry which the independent audit seeks to address. Audits promote high quality financial reporting, which reduces the information asymmetry between management and investors. Externalities are costs and benefits affecting a party that did not choose to incur that cost or benefit. Externalities often lead to sub-optimal production decisions.

4.15.d After a recent financial crisis, Ruritania and all of its neighbors except one voted to enact stringent regulations prohibiting 100% mortgage loans. (A 100% mortgage is one where the borrower receives a loan amount equal to the total value of the property.) The Ruritanian government is now concerned that firms may leave Ruritania and base themselves in a country without the stringent regulation. This situation is best described as an example of

A: regulatory arbitrage. When a company chooses to relocate to a new jurisdiction to avoid regulation, this is an example of regulatory arbitrage. Regulatory capture leads to regulation intended to enhance the interests of regulated entities. Regulatory burden refers to the costs of regulation for the entity being regulated. The regulatory capture theory is based upon the assumption that a regulatory body will be influenced or even controlled by the industry that is being regulated. Regulatory differences between jurisdictions can lead to regulatory competition wherein regulators compete to provide the most business-friendly regulatory environment. Firms may use regulatory arbitrage to exploit the difference between the substance and interpretation of a regulation.