Auditing and property rights

This is the official published version. Copyright @ 2004 RANDThird-party audit provides incentives to an agent whose actions affect the value of an asset. When audit intensity and outcome are unverifiable, we show that with interim-participation constraints the optimal mechanism may use only the auditor's report, disregarding the agent's information. Furthermore, the auditor obtains the asset and the agent a monetary compensation, when a high asset value is reported. This suggests regulating renewable resources or utility networks by giving entrants the option to buy the right to use the asset at a predetermined price, and financially rewarding incumbents for good performance.The second author used financial support of the Communaute francaise de Belgique (projet ARC 98/03-221) and EU TMR Network contract no. FMRX-CT98-0203

Reforming Punishment of Financial Reporting Fraud

Present sentencing law in criminal cases of financial reporting fraud is embarrassingly flawed. The problem is urgent given that courts are now regularly sentencing corporate offenders, sometimes (but sometimes not) to extremely punitive terms of imprisonment. Policing of fraud by multiple jurisdictions in a federal system means that principled sentencing law is necessary not only for first-order policy reasons but also for coordination of sanctioning efforts. Proportionality and rationality demand that sentencing law have an agreed scale for measuring cases of financial reporting fraud in relation to each other, a sound methodology for fixing a given case on that scale, and a reasoned calibration of that scale. Current federal law, which controls most such cases and is a focal point for non-federal cases and public debate, is close to sensible on the first score but far off the mark on the other two. In this contribution to a symposium on Fraud and Federalism, I describe problems in present law and offer relatively uncontroversial reform measures that could substantially improve the law governing sentencing of financial reporting fraud

Incentives-Based Mechanism for Efficient Demand Response Programs

In this work we investigate the inefficiency of the electricity system with strategic agents. Specifically, we prove that without a proper control the total demand of an inefficient system is at most twice the total demand of the optimal outcome. We propose an incentives scheme that promotes optimal outcomes in the inefficient electricity market. The economic incentives can be seen as an indirect revelation mechanism that allocates resources using a one-dimensional message space per resource to be allocated. The mechanism does not request private information from users and is valid for any concave customer's valuation function. We propose a distributed implementation of the mechanism using population games and evaluate the performance of four popular dynamics methods in terms of the cost to implement the mechanism. We find that the achievement of efficiency in strategic environments might be achieved at a cost, which is dependent on both the users' preferences and the dynamic evolution of the system. Some simulation results illustrate the ideas presented throughout the paper.Comment: 38 pages, 9 figures, submitted to journa

Who Blows the Whistle on Corporate Fraud?

What external control mechanisms are most effective in detecting corporate fraud? To address this question we study in depth all reported cases of corporate fraud in companies with more than 750 million dollars in assets between 1996 and 2004. We find that fraud detection does not rely on one single mechanism, but on a wide range of, often improbable, actors. Only 6% of the frauds are revealed by the SEC and 14% by the auditors. More important monitors are media (14%), industry regulators (16%), and employees (19%). Before SOX, only 35% of the cases were discovered by actors with an explicit mandate. After SOX, the performance of mandated actors improved, but still account for only slightly more than 50% of the cases. We find that monetary incentives for detection in frauds against the government influence detection without increasing frivolous suits, suggesting gains from extending such incentives to corporate fraud more generally.

Impact of Valuation Ranking Information on Bidding in First-Price Auctions: A Laboratory Study

Landsberger, et al. (2001) have identified optimal bidder behavior in first-price private-value auctions when the ranking of valuations is common knowledge, and derived comparative-statics predictions regarding the auctioneer's expected revenue and the efficiency of the allocation. The experiment reported here tests the behavioral components of these comparative-statics predictions using the dual-market bidding procedure, which permits very powerful tests. The results support the predictions that buyers are inclined to bid more aggressively when they learn they have the low value. Contrary to theory, buyers are inclined to bid less when they learn they have the high value. Once information is revealed, bidders tend to move toward better responses, exploiting new economic opportunities. Consistent with theory, the overall proportion of efficient allocations is lower than in the first-price auction before information is revealed. But as a result of high-value bidders decreasing their bids, the expected revenue does not increase on a regular basis, contrary to the theory's predictions.Asymmetric auctions, laboratory experiments, affiliation and economics of information

Does the market kill bad ideas? An institutional comparision of committees and markets in network industries

The paper analyzes the problem of protocol coordination between two firms, where one firm has private information about its own protocol. The institutional characteristics of the market and the class of strategies adopted by the firms admit multiple equilibria in the market. Of these, one particular equilibrium has an interior information revelation cutoff for the firm with private information. This demonstrates that the market might not be able to "kill bad ideas", but it does "reward good ideas". In contrast, the institutional design of the committee ensures that the same class of strategies gives rise to a unique equilibrium in the committee, with the informed firm revealing all private information. The committee game results generalize easily to multiple periods as well as to multiple firms and is robust to an exit option. The market game result holds for a certain range of parameter values for multiple firms.Networks, standardization, coordination, asymmetric information, institutional design

Optimal Assignment of Durable Objects to Successive Agents

This paper analyzes the assignment of durable objects to successive generations of agents who live for two periods. The optimal assignment rule is stationary, favors old agents and is determined by a selectivity function which satisfies an iterative functional differential equation. More patient social planners are more selective, as are social planners facing distributions of types with higher probabilities for higher types. The paper also characterizes optimal assignment rules when monetary transfers are allowed and agents face a recovery cost, when agents' types are private information and when agents can invest to improve their types.Dynamic Assignment ; Durable Objects ; Revenue Management ; Dynamic Mechanism Design ; Overlapping Generations ; Promotions and Intertemporal Assignments

Earmarking: Bundling to Signal Quality

Earmarking is a form of bundling in which government adopts a tax policy while specifying the uses of the revenue. This paper explores how bundling can enhance efficiency: it can inform the public of the quality of a program proposed, or of the quality of the agency that will be responsible for designing and implementing the program.We show that policies that appear inefficient in isolation may become justified when bundled.Earmarking; Asymmetric information; Bureaucracy; Project evaluation

Regulation of network industries in the European Union and in Central and Eastern Europe

Cost-based pricing has dominated the regulatory regime of network industries - and first of all, the regulation of the infocommunications sector - in the European Union since the early 1990s. When privatization of network industries began in Central and Eastern Europe (CEE), one of the main stumbling blocks on the road toward privately owned telecomm companies and postal services, energy producers and distributors, and other network industries was the lack of efficient and up-to-date industry regulations. From the mid-1990s, accessing countries that later became members of the EU, and other CEE countries that are still waiting for admission swiftly adopted the regulatory framework of the European Union. The EU has been striving for market opening and liberalization in these industries; it abolished industry regulation in several segments of the market of network industries. Now it applies so-called cost-based pricing in areas where regulation is still in place. CEE countries now use the same type of regulation as the advanced member states of the EU. But the regulatory capacity of most CEE countries is still far behind of their West European counterparts. Experts of network industries advocate, and telecommunications, energy and other market regulators in various parts of the world practice, cost-based pricing for inter-firm network access services. Cost-based pricing is carried out under the assumption that the regulator has perfect information regarding the costs of producing the services. We show in this paper that - under fairly general conditions - cost-based pricing creates incentives for regulated firms not to improve their efficiency. We also show that cost-based pricing results in smaller consumer welfare than incentive regulation that takes into account the existence of information asymmetry between the regulator and the firm. A model of interconnection with adverse selection and moral hazard is presented. --network industries,regulation,incentive contracts