Regulation consists of rules administered by government agency to influence economic activity by determining prices, product standards and types, and the conditions under which new firms may enter an industry.

In the U.S. the Interstate Commerce Commission was established and railroads were brought under economic regulation in 1887 to protect shippers - especially farmers - from monopoly power. A half a century later - during the great depression of the 1930's - numerous agencies were created for the regulation of a wide variety of other firms, including those engaged in finance, energy, and transportation. This wave of regulation reflected a belief that free markets were not working well rather than a concern about market power.

In general, free markets produce efficient outcomes. Because of informational frictions and externalities, however, there is a need for regulation. For example, asymmetric information can cause adverse selection and moral hazard, which are both examples of market failure situations, and regulators attempt to address.

A negative externality is a cost that a transaction or activity imposes on a party that is not part of the transaction or activity. Examples: pollution, loud noise, and blocked view. A negative externality could lead to a market failure. When production or consumption of a product benefits others, it is a positive externality.

Regulations can address both positive and negative externalities. For example, negative externalities should be taxed, and positive externalities should be subsidized.

Practice Question 1

Over 40% of New York stock-exchange-listed companies, and over 50% of Fortune 500 companies, are incorporated in Delaware. As part of this process, Delaware, "a pygmy among the 50 states prescribes, interprets, and indeed denigrates national corporate policy as an incentive to encourage incorporation within its borders, thereby increasing its revenue" (Cary, supra, n.5, 701.). This phenomenon is referred to as:

A. Regulatory attraction.
B. Regulatory competition.
C. Regulatory advantage.

Correct Answer: B

This is perhaps the best known case of regulatory competition which seems to create a "race to the bottom" in standards.

Practice Question 2

Desirable attributes of regulation include:

I. predicable.
II. stable.
III. unchanging.

Correct Answer: I and II

Stable does not mean unchanging.

Practice Question 3

Examples of negative externalities include:

I. systemic risk.
II. financial contagion.
III. market crash.

Correct Answer: I and II

Definition of negative externality.

Practice Question 4

A written law enacted by legislative bodies is a:

A. statute.
B. administrative law.
C. judicial law.

Correct Answer: A

Practice Question 5

All self-regulating organizations are:

A. regulators.
B. independent regulators.
C. None of the above is true.

Correct Answer: C

A is false. They are if they are given recognition and authority by a government body and agency.

B is false. Not all of them are independent. Only those given recognition and authority by a government body and agency are independent regulators.

Practice Question 6

An insured person may choose to conceal certain unhealthy habits or genetic traits that make the health insurance attractive for the person but unprofitable for the company. This is an example of:

A. adverse selection.
B. moral hazard.
C. regulatory capture.

Correct Answer: A

The person getting insured has more information about the quality of his or her health than the insurance company.

Practice Question 7

After getting insured, the person is more careless about health. For instance, he/she may take fewer dietary precautions, smoke or drink more, or indulge in physical activities dangerous to the health. This is an example of:

A. adverse selection.
B. moral hazard.
C. regulatory capture.

Correct Answer: B

While in adverse selection, the seller is usually the one possessing more information, moral hazard usually has the buyer (of the insurance service) having too much control.

Practice Question 8

This funny Tom Toles cartoon appeared in the Washington Post on January 20,2011.

It is about:

A. regulatory capture.
B. regulatory competition.
C. regulatory arbitrage.

Correct Answer: A

One of the consistent outcomes arising from regulatory capture is that the regulated industry can use regulation in ways to increase its benefits at the expense of consumers.

Practice Question 9

When small financial shocks, which initially affect only a few financial institutions, spread to the rest of financial sectors, it is referred to as:

A. systemic risk.
B. financial contagion.
C. regulatory arbitrage.

Correct Answer: B

Practice Question 10

Which law defines rights and duties of entities?

A. Judicial law.
B. Substantive law.
C. Procedural law.

Correct Answer: B

A procedural law is the "machinery" for enforcing those rights and duties.

Practice Question 11

An example of adverse selection is when sellers have information about some aspect of product quality, but buyers don't. Adverse selection is an example of:

A. informational frictions.
B. positive externalities.
C. negative externalities.

Correct Answer: A

Adverse selection: private information in the hands of SOME, but NOT ALL, market participants, which affects the consumption of goods or services.

Practice Question 12

With respect to the originators of subprime loans, many may have suspected that the borrowers would not be able to maintain payments and that, for this reason, the loans were not, in the long run, going to be worth much. Still, because there were many buyers of these loans (or of pools of these loans) willing to take on that risk, the originators did not concern themselves with the potential long-term consequences of making these loans. After selling the loans, the originators bore none of the risk so there was little to no incentive for the originators to investigate the long-term value of the loans. This is an example of:

A. adverse selection.
B. moral hazard.
C. regulatory capture.

Correct Answer: B

A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party isolated from risk behaves differently from how it would if it were fully exposed to the risk.

Practice Question 13

In his new book, "The Fine Print: How Big Companies Use 'Plain English' to Rob You Blind", David Cay Johnston highlights one of the key problems in the U.S. "The telecos got the rules changed while we weren't watching. Basically, the phone and cable companies lobbied Washington to change laws and regulations to favor their businesses over their customers." According to Johnston, this is a typical example of:

A. regulatory capture.
B. regulatory competition.
C. regulatory arbitrage.

Correct Answer: A

Regulatory capture is the process by which regulatory agencies eventually come to be dominated by the very industries they were charged with regulating. Regulatory capture happens when a regulatory agency, formed to act in the public's interest, eventually acts in ways that benefit the industry it is supposed to be regulating, rather than the public.

Practice Question 14

Which organization is a regulator?

A. International Accounting Standards Board (IASB).
B. Moody's.
C. U.S. Securities and Exchange Commission (SEC).

Correct Answer: C

Regulators may reference the work of IASB's or credit rating agencies' in their regulations. The SEC is the government agency that regulates the securities markets in the U.S.

Practice Question 15

In an unusual move, Blackstone went public in 1997 as a master limited partnership in an effort to avoid the higher tax rates imposed on corporations. In order to retain these tax advantages, Blackstone also had to avoid classification as an investment company. This practice is often referred to as:

A. Regulatory advantage.
B. Regulatory circumvention.
C. Regulatory arbitrage.

Correct Answer: C

Regulatory arbitrage is the use of regulation by an entity to exploit differences in economic substance and regulatory interpretation or in regulatory regimes to the entity's benefit. Through carefully negotiating the tax regulations, Blackstone hopes to exploit a 'regulatory arbitrage' between the tax code's legal definitions and economic substance.

Practice Question 16

The FASB is:

A. an independent regulator.
B. a self-regulating organization.
C. both an independent regulator and a self-regulating organization.

Correct Answer: B

The FASB issues accounting standards and guidance, but it has no regulatory powers. Self-regulating organizations given recognition and authority by a government body or agency are independent regulators.

Practice Question 17

Which statement is true regarding regulation?

A. Because of regulatory interdependencies across jurisdictions the authors in the textbook suggest global governance to replace regional, national and local regulators.
B. Without frictions and externalities, regulations would not be necessary.
C. There is no need for regulations to deal with positive externalities.

Correct Answer: B

A is false. The purpose is to recognize the reality and implications of diverse trade-offs and preferences among regional, national and local regulators.

B is true. Market solutions would be adequate for all situations without frictions and externalities.

C is false. Regulations are needed for both negative and positive externalities.

Practice Question 18

The idea that regulations are supplied to satisfy the self-interest of producers to maximize economic profit is known as

A. public interest theory.
B. capture theory.
C. regulation theory.

Correct Answer: B

Regulatory capture occurs when a regulatory agency, created to act in the public interest, instead advances the commercial or special concerns of interest groups that dominate the industry or sector it is charged with regulating.