Direct controls and incentives systems of regulation

Abstract The focus of this paper is regulatory enforcement when regulators do not have absolute power—as is the case when procedures of due process and the right of appeal allow regulated enterprises to challenge decisions of regulatory agencies. Instead of passively submitting to regulatory enforcement, the regulated enterprise can contest the regulator's decisions. Given this contestable view of regulatory enforcement, two regulatory models are compared: regulation with direct controls where the regulator issues directives and commands to directly regulate behavior and incentives-based regulation where fines or corrective taxes are used. In both types of regulation the regulated enterprise can contest the regulator's decisions. In the first the firm may challenge the regulator's directives, while in the second the firm can contest fines levied by the regulator. The question is, which regulatory regime can obtain higher compliance? The results suggest that when the regulator's enforcement powers are limited, regulation with direct controls can obtain higher levels of compliance than an incentives-based system.

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