Entrepreneurship and Public Policy Lecture 4: Role of Regulation in Entrepreneurship Public Policy

EPP – Lecture 4 -2 Spring 2009 Background on This Lecture The regulatory environment tends to make distinctions among firms in terms of their size, not their age, rate of growth or degree of innovation Thus, in this lecture we will focus on firm size as a proxy for entrepreneurship Summarize key differences in how the regulatory environment affects large and small firms differently Discuss how liability system may act as an alternative to regulation

EPP – Lecture 4 -3 Spring 2009 Lecture Overview Background on regulation and entrepreneurship Liability system as an alternative to regulation –What is tort liability? –Liability and Small Business –Liability as a Privatized Regulatory System

EPP – Lecture 4 -4 Spring 2009 Most Regulations Were Developed To Regulate Large Firms Regulations addressed concerns about the effects of large businesses on society: –High predatory prices charged by monopolists –Unfair labor practices exercised by large employers –Large manufacturer’s ability to subvert the tort system designed to protect consumers The objectives of these regulations –Promote market competition –Control large market power of large firms over customers and smaller firms –Mitigate or prevent the adverse effects of businesses activity (negative externality) on individuals, organizations, and the environment

EPP – Lecture 4 -5 Spring 2009 Most Regulations Were Developed To Regulate Large Firms Regulations addressed concerns about the effects of large businesses on society: –High predatory prices charged by monopolists –Unfair labor practices exercised by large employers –Large manufacturer’s ability to subvert the tort system designed to protect consumers The objectives of these regulations –Promote market competition –Control large market power of large firms over customers and smaller firms –Mitigate or prevent the adverse effects of businesses activity (negative externality) on individuals, organizations, and the environment

EPP – Lecture 4 -6 Spring 2009 Regulation May Provide Different Treatment to Small Firms than to Large Firms Differential treatment may stem from the actions of legislators or government agencies Differences arise from several sources: –Exempting certain types of businesses from regulation –Different implementation requirements for large and small firms –Applying different enforcement mechanisms to different types of firms In addition, small firms may respond differently to regulation than larger firms

EPP – Lecture 4 -7 Spring 2009 Special Attention to Small Firms Arises from Concerns about Burden of Regulation on Firms Policy makers adjust the application or enforcement of regulation according to firm size due to the belief that a given regulation will impose a greater relative costs on a smaller firm –Financial costs –Personnel costs –Resource costs

EPP – Lecture 4 -8 Spring 2009 Burden of Regulation May Indeed be Higher for Small Businesses than for Large Ones The costs per employee for firms with less than 20 workers is $7,647 while in large firms $5,411 Costs burden is especially large on small firms in manufacturing sector In services sector costs of regulation differ little between large and small firms Relative costs of compliance depend on specific regulation –Compliance with environmental regulations costs 364 percent more in small firms than in large firms –The cost of tax compliance is 67 percent higher in small firms than the cost in large firms –The cost per employee of workplace regulations falls most heavily on medium-sized firms

EPP – Lecture 4 -9 Spring 2009 Policy Makers Should Also Consider Possible Benefits of Regulations Regulation may provide benefits to firms and to society –Preventing injury and other bad outcomes Relative burden and benefit of regulation may vary with firm size –Magnitude of costs may vary –Relative risks or harms (i.e. rates of injury or death) may vary by firm size Although we know little about costs of regulation we know even less about potential benefits of regulation by firm size There is little evidence that small businesses exemptions are crafted in a way that appropriately balances the costs and benefits of regulation

EPP – Lecture Spring 2009 In Sum, Policymakers Need to Balance Desire to Support Small Businesses with the Objectives of Regulation Regulations may impose disproportionately high costs on smaller firms Regulations may not achieve their purpose due to exemptions made to small firms

EPP – Lecture Spring 2009 Lecture Overview Background on regulation and entrepreneurship Liability system as an alternative to regulation –What is tort liability? –Liability as a Privatized Regulatory System –Liability and Small Business

EPP – Lecture Spring 2009 What is the tort liability system? A “tort” is an injury or breach of duty to another person Under the U.S. system of tort liability, courts can hold injurers liable for many different types of torts –Automobile accidents –Contract fraud –Trespass –Medical malpractice –Injuries associated with defective products

EPP – Lecture Spring 2009 Many Concerns About Tort Liability System Expressed by Critics High transaction costs Does it lead to an anti-innovation bias? –Lack of predictability Punitive damages and noneconomic damages Juries Forum shopping Legal change may not be toward more efficient system –Current practice is a defense in tort cases (Parchamovsky and Stein) –Regulatory compliance not a defense –Securities litigation is particularly controversial Abuse and fraud

EPP – Lecture Spring 2009 It is Difficult to Collect Data On Tort System Outcomes Tort cases are private disputes and direct costs are difficult to measure –Many settle out of court and terms of settlement are private Difficult to measure indirect costs of the system –The costs of efforts to prevent or avoid injuries –Opportunity costs of goods and services that are not provided –Distribution costs of plant closings and bankruptcies Benefits of the system equally difficult to measure –We do not observe reduction in possible cost of injuries that arise from precautions taken by potential injurers Much of the data that are available present different picture than critics of the system present

EPP – Lecture Spring 2009 Many States Implemented “Reforms” of the Tort Liability System Most policy responses are state specific Components of reform efforts typically include: –Caps on non-economic or total damages –Abolition of punitive damages –No mandatory prejudgment interest –Collateral-source rule reform –Caps on contingency fees –Mandatory periodic payments –Limitations on joint and several liability –Limits on forum shopping

EPP – Lecture Spring 2009 Lecture Overview Background on regulation and entrepreneurship Liability system as an alternative to regulation –What is tort liability? –Liability and Small Business –Liability as a Privatized Regulatory System

EPP – Lecture Spring 2009 Tort System to Could Have a Different Effect on Small Versus Large Businesses Theoretical predictions about the effect of liability system on small businesses are ambiguous Large firms may be more attractive targets –“Deep pockets” Small firms may be more attractive targets –Lower ability to mount an effective defense campaign –May rather settle then litigate –May not be able to protect personal assets If the system favors one size firm, does the other benefit?

EPP – Lecture Spring 2009 Empirical Evidence about the Effects of Liability on Small Businesses is Limited A recent survey found that the cost and availability of liability insurance is the #2 concern of small businesses SBA (2005) –36 to 53 percent of federal lawsuits involved a firm with 50 or fewer employees –Litigation costs to small business owners range from $3,000 to $150,000 –Litigation also imposes emotional burden Pendell and Hinton (2007) –Tort system costs “small” businesses $98 billion a year –The cost of the tort system to individual “small” businesses $20.11 per $1,000 of revenues vs $1.33 for “large” firms What does any of this mean?

EPP – Lecture Spring 2009 RAND Research Provides Empirical Test of Impact of Tort Reform on Small Businesses Romley and Savych (2008). “Does liability affect small business”. RAND-WR-541-EMKF (2007) Uses differences in caps across states and over time to measure liability impact Examines the number of firms in an industry-time- location Overall, the study finds little evidence that caps increase the number of small businesses

EPP – Lecture Spring 2009 Lecture Overview Background on regulation and entrepreneurship Liability system as an alternative to regulation –What is tort liability? –Liability and Small Business –Liability as a Privatized Regulatory System

EPP – Lecture Spring 2009 Tort Liability System May Help Serve Important Policy Goals Compensating victims Holding injurers responsible for their actions Provide incentives for efficient behavior –Incentives for precaution, investment in safety, and avoiding the negative externality Critics of tort system rarely answer the question: Compared to what?

EPP – Lecture Spring 2009 Liability Can Be Seen as an Alternative to Regulation for Limiting Potential Harm Two systems attempt to limit potential form harm differently –Litigation is private, encourages safety through deterrence, and is imposed ex post –Regulation is public, encourages safety through social command, and operates ex ante When does liability make more sense than regulation? (Shavell, 1984) –When private parties and courts have superior knowledge –When private parties are capable of paying for the full harm –When administrative costs are lower for using the tort system –When injured parties are likely to bring claims

EPP – Lecture Spring 2009 Privatized Regulation and Litigation Finance If litigation is costly and financing is unavailable, tort system will not effectively induce firms to internalize the cost of potential harms In most common law countries, it is considered unethical to profit from another’s lawsuit In the United States, since the mid-19 th century, plaintiff’s attorneys can charge contingency fees –One-third of award or pay nothing –Still unavailable in most other countries The trends in legal aid The rise of conditional fees

EPP – Lecture Spring 2009 Class Actions and Aggregation Costs of individual suit may not justify bringing suit even when costs to society are large If there are many similar suits, plaintiff’s attorneys in the US can bring class actions –Individuals in class are often required to opt-out –Attorneys charge contingency fee on aggregate award or settlement –Class actions becoming increasingly common abroad Mass torts are not always class actions –Growing array of options for aggregation Plaintiff’s attorneys and class may have divergent interests –Alternative approaches to litigation finance may help

EPP – Lecture Spring 2009 Tort Liability and Entrepreneurship Tort liability in the US is a privatized regulatory system driven by entrepreneurial attorneys –Contingency fees provide incentives to attorneys to prioritize the largest harms –May be a better way to regulate safety in a complex modern economy –Many US innovations are being adopted abroad

EPP – Lecture Spring 2009 Discussion Question Tort liability in the US is a privatized regulatory system driven by entrepreneurial attorneys –Contingency fees provide incentives to attorneys to prioritize the largest harms –May be a better way to regulate safety in a complex modern economy –Many US innovations are being adopted abroad Can entrepreneurship improve the civil justice system in other ways? –Private dispute resolution is replacing juries –Information technology may improve predictability How does the tort system impact growth and innovation?