The public management of risk: Separating ex ante and ex post monitors

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Abstract

When a firm undertakes risky activities, the conflict between social and private incentives to implement safety care requires public intervention which can take the form of both monetary incentives and also ex ante or ex post monitoring, i.e., before or after an accident occurs. We delineate the optimal scope of monitoring depending on whether public monitors are benevolent or corruptible. We show that separating the ex ante and the ex post monitors increases the likelihood of ex post investigation, helps prevent capture and improves welfare.

Introduction

Although much debated and often criticized, the view that our societies are ‘at risk’1 has certainly pushed both scholars and practitioners to reconsider the role of public intervention in the field of risk regulation.2 Consumers should be protected against buying defective products, patients against medical malpractice, workers against accidents in the workplace, the environment against major industrial or transportation hazards, etc. In all these circumstances and although risk tolerance may vary, public intervention is called for to control private actors involved in activities that put humans or the environment at risk. As risks spread over the whole spectrum of economic activities, more effort and expertise should be allocated to assess their true impact on society. The adequate design of incentives for key players involved in the management of these risks should be put at the forefront of the public debate.

Maintaining risk at levels which are socially acceptable does require systems of control. This issue has attracted much attention in the public management literature with a strong motivation being to explain the great variety of regimes in risk regulation across fields and countries.3 However, little is known on the design of adequate institutions for risk regulation. Institutions do vary significantly across fields. Casual evidence suggests that, sometimes, administrative agencies are staffed with experts able to assess specific risks and these agencies have strong enforcement powers. A typical example is that of nuclear power plants, which are routinely checked for maintaining safety. In other fields, such as defective products, agencies are more generalist and most of the enforcement power resides with Courts of Law that perform their own investigation in case of prosecution following an accident. Most of the time however, risk regulation involves an intricate combination of both kinds of intervention taking place either ex ante or ex post. Transportation, road and navigation safety, or occupational safety are good illustrations.

One might argue that risk regulation fits into the general grid already available to discuss regulatory policies and institutions for market regulation.4 However, there is some value in distinguishing agencies and regulations which are used ex ante, i.e. before any accident occurs, from agencies, Courts of Law and other enforcement devices which may intervene ex post, i.e. after an accident. This time line naturally distinguishes the roles of different public officials involved in risk monitoring.

In this respect, an important but largely unexplored issue is to delineate the optimal scope of ex ante and ex post controls in a world plagued with informational constraints. This paper discusses the costs and benefits of splitting the tasks of ex ante and ex post monitorings of a firm, the activity of which generates some risk. This is done in a context where moral hazard on safety care calls for explicit monetary incentives but also for setting up auditing mechanisms to force compliance with safety standards. When capture of monitors by the very interests they are supposed to control is a concern, separation of monitoring tasks between two independent bodies is preferable.

Consider a risk-neutral firm which can cause an accident of substantial scale affecting third-parties. This firm undertakes a nonverifiable prevention effort. A high level of effort is socially optimal. Compliance with this standard of due care can be induced through monetary incentives and the threat of random inspections. Such monitoring might either be preventative (ex ante) or only occur ex post, following an accident, and uncovers whether the firm did perform sufficient care. Fines can be imposed if investigation reveals misconduct, but the firm is protected by limited liability. This access to privileged information gives discretion to public officials. The firm may attempt to capture monitors to prevent them from revealing its misbehavior.

Had monitors been non-corruptible, monitoring would unambiguously improve the firm's incentives. Things are different when monitors are corruptible.

Consider first the case where ex ante and ex post monitorings are performed by a single entity. Such an integrated organization opens large opportunities for collusion. The long-term relationship between an integrated monitor and the firm facilitates collusion by expanding the set of contingencies in which bribes can be exchanged. Under integration, the monitor's close contact with the firm significantly reduces the transaction costs of side-contracting. Postulating convex transaction costs in side-transfers, average transaction costs decrease as bribes are spread over more contingencies.5 Intervening both ex ante and ex post, an integrated agency reduces such transaction costs and reaches more efficient collusive deals with the regulated firm.

Under separation, different monitors are used ex ante and ex post. Each monitor anticipates that the other receives enough benefits from adopting an uncorrupted behavior. When striking their collusive deal, the firm and the ex ante monitor anticipate that another monitor may intervene ex post to unveil both the firm's misconduct and evidence of corruptible deals. Bribes can only be transferred when they cannot be detected by an ex post investigation. Smoothing bribes with the ex ante monitor becomes harder and transaction costs of collusion increase. Diseconomies of scale in side-contracting appear, making it easier to prevent capture.6 Because it reduces the social cost of preventing capture, ex post monitoring takes place more often under separation than under integration. As its capture is less likely under separation, the ex ante monitor is called upon more often. This highlights a complementarity between ex ante and ex post monitorings. Taking a broader perspective, tougher ex ante regulation and ex post judicial prosecution should come together.

Our analysis sheds some light on a number of recent institutional changes.

Air transportation offers an illustration of primary interest for our analysis. The investigation of airplane transportation accidents in Canada was, for many years, fully carried out by the Department of Transport. It set the safety standards for the industry, operated elements of the system such as airports and air traffic control, licensed the carriers and the crews, and enforced its own regulations. At the same time, it analyzed the safety failures in the industry in which it had such a pervasive presence. The concern about the independence of the regulator from the industry grew so heatedly that the government proceeded with the creation of the Canadian Aviation Safety Board, an independent regulatory body with an accident investigation mandate. In the framework of our model, this institutional reform is a move towards separation.

In this sector, a broad set of precautionary activities can be implemented at the firm level to reduce the likelihood of an accident: care during transportation, employee training programs and radiation competency tests, adoption of best-practice for containment and radiation shielding, integrated safety management, etc. The U.S. Department of Energy (D.O.E.) has inherited the task of cleaning up the radioactive refuse from uranium mines, munitions facilities and other sites around the country. Inside D.O.E., until recently, the Office of Environment, Safety and Health (O.E.S.H.) developed safety policy guidance and provided support to D.O.E. sites, while the Office of Security and Safety Performance Assurance (O.S.S.P.A.) conducted safety oversight. The former office mainly ensures that regulated firms comply with the safety standards whereas the latter office mainly investigates accidents. Recently, the D.O.E. has announced the creation of a new office (the Office of Health, Safety and Security) which will undertake enforcement activities previously carried out by both the O.E.S.H. and O.S.S.P.A. This decision is clearly a move towards integration of the tasks of ex ante and ex post monitorings. Our results below cast doubts on the wisdom of such a move.

The idea that splitting access to privileged information between specialized agencies reduces the costs of capture has previously been investigated by Laffont & Martimort, 1998, Laffont & Martimort, 1999. Several important differences exist with the present setting. First, both the ex ante and ex post monitors have access to the same piece of information (albeit at different points in time due to the specific features of risk regulation), namely the agent's level of safety care, whereas separated agencies get access to different pieces of information in LM. Second, another difference comes from the source of the economies of scale in side-contracting. In LM, “Chinese walls” between regulators create asymmetric information in side-contracting. This undermines the efficiency of the side-deals that each regulator reaches with the firm. Here instead, the collusive gains from integration come from the fact that a single regulator can better smooth bribes over the different states of nature.7 Third, in LM, the monitoring technologies that give informative signals to the firm's monitors are exogenously given whereas we devote some attention to the impact of different institutional choices on the endogenous likelihood of each round of investigations.8

Other contributions have highlighted the costs and benefits of splitting public bodies. On the benefits side, Kofman and Lawarée (1993) show that bringing an uncorruptible monitor may limit the scope for capturing corruptible ones. Our model instead does not assume a priori that this extra monitor is uncorruptible but derives the benefits of separation in a model where both ex ante and ex post supervisors can be captured. Kofman and Lawarée (1996a) find that competing agencies may be useful in a yardstick model where they acquire correlated signals. In our model, monitors have instead access to different signals which are conditionally independent and such yardstick mechanisms lose appeal. On the costs side, Shleifer and Vishny (1993) study the optimal number of public officials controlling a given firm. Public officials choose non-cooperatively the bribes they require. In equilibrium, excessive bribery occurs with several officials. Although such a result might be convincing in weak institutional environments, the stake for bribery in Shleifer and Vishny (1993) is exogenous and no attention is given to possible institutional responses aimed at limiting the wasteful competition between bureaus. Instead, in our model, this stake arises endogenously from asymmetric information. We give a particular attention on the institutional response to the threat of capture, not only in terms of incentives for public bodies, but also in terms of their overall organization.

Finally, the literature on corruption in law enforcement (Becker & Stigler, 1974, Mookherjee & P'Ng, 1995, Garoupa, 1997, Polinsky & Shavell, 2001) analyzes the impact of corruption on the likelihood of investigation in various contexts but does not draw, as we do, the implications of corruption for institutional design. Corruption is an equilibrium phenomenon in these models. In our context instead, the Collusion Proofness Principle9 always holds so that institutions are robust to the threat of capture. The best institutional form minimizes the cost of preventing capture. This institutional perspective is also the focus of Boyer & Porrini, 2001, Boyer & Porrini, 2004 who compare ex ante regulation and various liability rules enacted ex post. They postulate a priori that the legal system viewed as an ex post monitor is immune to capture, whereas we derive this result from equilibrium behavior. In addition, they analyze separately the costs and benefits of the two systems whereas we model their joint use.10 Section 2 presents our theoretical model. Section 3 studies the benchmark without collusion. Section 4 describes our modeling assumptions for capture and studies the impact of collusion on monitoring under integration and separation. Section 5 performs a welfare comparison between institutional modes and highlights the possible complementarity between ex ante and ex post monitorings that might arise endogenously under separation. Section 6 discusses some implications of our results and presents several extensions. Section 7 concludes. All proofs are in Appendix A.

Section snippets

The model

Consider a firm running a socially risky technology. The probability of an accident affecting third-parties is reduced when this firm implements some safety care. Moral hazard in choosing this variable calls for controlling whether the firm abides to a standard of due care or not.

Benevolent monitors

Let us suppose that the ex ante and ex post monitors are both benevolent. There is no need to pay any positive wage to induce these monitors to reveal informative signals on the firm's effort. In such an environment, separation and integration are clearly equivalent.

Ex ante monitoring punishes the firm since it suppresses rewards following a good environmental performance when misconduct is detected. Ex post monitoring is useless because it does not help to relax the firm's incentive constraint

Collusive side-contracts

A firm might bribe its monitors so that they hide information on misconduct. Bribes might take the form of promises for future job opportunities in the private sector for current regulators, direct monetary bribes or campaign contributions targeted towards lawmakers and key elected officials who have influence at the various stages of the firm's monitoring.

As already mentioned, the firm has at its disposal some hidden wealth w > 0 for bribing its monitors.30

Welfare comparison

Only the wages left for ex ante monitoring differ in both scenarios. For some fixed investigation probabilities (pr,pj), the welfare difference between separation and integration is just the difference in these wages, which are respectively given by VrI(pr) = k(π0t(pr,ϵ)) under integration, and VrSpr,pj=αkπ0tpr,εα under separation. We obtain:ΔWpr,pj=prϵVrIprVrSpr,pj=prϵkπ0tpr,ϵαkπ0tpr,ϵα.

Since α < 1, t(pr,ϵ) > 0 and k(·) is strictly concave, ∆W > 0 and we can establish the main result of this

Testable implications

Our analysis provides a number of testable implications. Suppose that separating ex ante and ex post monitorings requires setting up a new agency with a fixed set-up cost K > 0. Formula (17) shows that ∆W(pr,pj) is more likely to be greater than K under several circumstances which can be related to the monitoring and production technologies available in the public and the private spheres. First, separation is attractive when pr and pj are both large enough, i.e. when the administrative costs of

Conclusion

This paper has stressed the benefits of splitting ex ante and ex post monitorings of environmentally risky ventures in a moral hazard environment. Having an independent ex post monitor intervening only upon an accident makes it more difficult for the firm to collude with the ex ante monitor whose control is more routinized. Regulatory capture is less of a concern under separation and this institutional choice improves social welfare.

Although our model generates some value for separation to

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    Financial and intellectual support from the French Ministry of Ecology and Sustainable Development are acknowledged. We are grateful to Bernard Caillaud, Giacinta Cestone, David Encaoua, David Ettinger, Denis Gromb, Jean-Pierre Ponssard, Bernard Salanié, Wilfried Sand-Zantman, Jean Tirole, participants at various seminars, two referees and one Editor for helpful comments. All errors are ours.

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