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Cost-Benefit Analysis in U.S. Regulation Eric A. Posner University of Chicago Law School 1.

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Presentation on theme: "Cost-Benefit Analysis in U.S. Regulation Eric A. Posner University of Chicago Law School 1."— Presentation transcript:

1 Cost-Benefit Analysis in U.S. Regulation Eric A. Posner University of Chicago Law School 1

2 Overview 1.What is cost-benefit analysis (CBA)? 2.The role of CBA in agency regulation Congress Executive branch Courts 2

3 Overview, cont. 3.The Theory of CBA Welfarism Transparency 4.Controversies Hard valuations: life, culture Uncertainty Discounting 5.The Future of CBA In the executive branch In the courts 3

4 1. What is CBA? Example: Regulator (Environmental Protection Agency) must decide whether power plants should install scrubbers in smokestacks. Costs: the cost of installing scrubbers x number of factories Benefits: avoided medical costs (for example, less emphysema) x affected people 4 RegulationBenefitsCostsNetDecision Weak$1 million$10 million- $9 millionReject Moderate$16 million$15 million+$1 millionCB-justified Strict$22 million$20 million+$2 millionOptimal Super-strict$23 million$30 million-$7 millionReject

5 What is CBA?, cont. Issues and problems Informal or rigorous? Determining costs Purchase price of scrubbers; maintenance costs; labor costs; etc. Predicting technological change that may reduce costs Determining benefits Research on effect of pollution on people’s health Research on medical costs What about intangible quality of life? Determining costs and benefits can be expensive! Data analysis 5

6 2. The Role of CBA in Agency Regulation U.S. government structure (roughly) Congress has set up numerous regulatory agencies Environmental Protection Agency (pollution) Securities and Exchange Commission (corporate disclosure) Office of the Comptroller of the Currency (bank safety and soundness) Occupational Safety and Health Administration (workplace safety) Congress gives agencies (usually) vague instructions to promote the public interest EPA: reduce “unreasonable risk to health and environment” SEC: consider effects on “efficiency, competition, and capital formation” Courts must ensure that agency complies with statute but difficult to enforce vague standards 6

7 Role of CBA in Agency Regulation, cont. Regulatory agencies are in executive branch Presidents have ordered regulators to use CBA since Reagan in 1981 When regulators issue regulations, they issue a Regulatory Impact Assessment (RIA) that contains the CBA The regulatory agencies send the RIA to the White House for review. White House can block or delay regulations that fail CBA In sum: 1.Agency performs CBA and chooses rule 2.If White House approves rule based on CBA, the rule is issued 3.Judicial review of rule based on statutory standard 7

8 3. The Theory of CBA Efficiency Welfarism The government should maximize well-being of the public Based on actual preferences as reflected in Willingness-to-Pay (WTP) CBA aggregates preferences by using market values Criticisms Government should not maximize well-being (vs. protect rights) Actual preferences do not reflect well-being Market values are distorted by wealth differences 8

9 Theory of CBA, cont. Transparency Regulators are agents in a bureaucracy President/Congress (or public) is the principal Agents’ incentives are not aligned with public interest (“moral hazard”) CBA forces regulators to reveal assumptions and expectations This allows democratically elected principal to correct them Criticisms WTPs are inaccurate CBA is manipulable 9

10 4. Controversies Hard valuations EPA’s regulation of cooling water intake structures in power plants Stricter regulations save fish. How much is a fish worth? Market valuation versus contingent valuation surveys OCC’s regulation of risk-taking by banks Stricter regulations reduce the risk of a financial crisis. How much is an avoided financial crisis worth? Justice Department’s regulation of prisons How much is an avoided prison rape worth? OSHA’s regulation of the workplace How much is an avoided death worth? 10

11 “The Value of a Statistical Life” Suppose a regulation would eliminate 100 statistical deaths but it would cost $1 billion. Does it pass CBA? Government normally uses $7 million value of a statistical life 100 x $7 million = $700 million < $1 billion Fails CBA. Where does $7 million figure come from? Based on studies of wage premiums for dangerous jobs Example: safe job (0 risk of death) pays $40,000 Dangerous job (1/10,000 risk of death) pays $40,700 Then VSL = $700 / (1/10,000) = $7 million 11

12 Uncertainty Climate regulation What effect does the reduction of greenhouse-gas emissions have on the risk that the global temperatures will increase by more than 2 degrees Celsius? Endangered species regulation How does one determine whether flat-tailed horned lizards are endangered? Nuclear waste regulation What risk does the storage of spent nuclear fuels pose to people living 10,000 years in the future? Bank regulation How much does increased capital requirements for bank reduce the risk of a financial crisis? 12

13 Discounting Regulations frequently create costs today and benefits in the future Climate regulation Nuclear waste regulation The usual method for comparing benefits and costs at different times is through discounting A future benefit of 100 is worth less than 100 today because of time preferences and interest A discount factor, δ < 1, is multiplied by future benefits; δ 2 for Year 2, and so on. E.g.: If the benefit is 100 in Year 2 and the cost is 80 today, then the regulation passes a CBA if 80 < δ 2 100 A great deal of controversy over what δ should be. Depends on rate of future economic growth, which is unknown. 13

14 5. The Future of CBA In the executive branch CBA is entrenched for many types of regulations, including environmental, and health and safety. OIRA (an agency in the White House) demands that regulators use standard valuations for life, discounting, etc. Controversy as to whether these rules have improved regulation Enforcement problems Unquantified benefits 14

15 Future of CBA, cont. CBA of financial regulation? Currently, financial regulators do not use CBA Some academics think they should. But difficulties: What are the benefits of financial regulation? Avoided financial crises. How to estimate risk and value? Avoided “speculation”/gambling Avoided high-speed trading and related activity Worries about evasion: from banks to “shadow banks” 15

16 Future of CBA, cont. CBA and Judicial Review Should courts enforce CBA? Or do they lack capacity to do so? Business Roundtable (2011) The SEC issued the “proxy access rule,” which required public corporations to place candidates nominated by large shareholders on the proxy statement sent around before board elections The purpose of the rule was to loosen management’s grip on the board, and hence to improve oversight of management 16

17 Future of CBA, cont. SEC conducted CBA Benefits Shareholders spend less money on printing and mailing Shareholders gain from better-managed firm Query: or will shareholders elect bad directors, hurting the firm? Costs Firms’ printing and mailing costs increase (est. $2-7 million per company) Firms may be distracted by election contests May distort choices between firms covered by rule and firms not covered by rule SEC claims benefits > costs, but also acknowledges that most benefits (and many costs) are not quantifiable 17

18 Court struck down proxy access rule SEC did not estimate cost of election contests when in fact it is likely that Board will oppose nominees SEC did not rely on sufficient empirical data showing that proxy access will improve board performance Academic studies were in conflict Court was heavily criticized for this decision Frequently not much data; hard to know whether regulator should gather more data or do the best it can with existing data Regulator is in better position than court to adjudicate among academic studies 18

19 Conclusion: CBA versus Democracy To what extent can public policy be based on empirical data and rigorous analysis? Normative questions: does CBA reflect what we care about? Data limitations To what extent should courts or expert agencies play a role in doing rigorous analysis? Courts derive authority from Congress (democracy?) Regulators are controlled by President (expertise?) CBA as a way to enhance democratic control over agencies while taking advantage of their expertise 19

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