Corrective Regulation with Imperfect Instruments
Abstract:
This paper studies optimal second-best corrective regulation when some decisions cannot be perfectly regulated. We show that policy elasticities and Pigouvian wedges are sufficient statistics to characterize the marginal welfare impact of regulatory changes. We show that leakage elasticities — a subset of policy elasticities — and Pigouvian wedges jointly determine optimal second-best corrective policy. We further characterize the marginal value of reforms that relax regulatory constraints. In an application to financial regulation with shadow banks, we show that empirical estimates of leakage elasticities can be used to directly determine the desirability of adjusting regulations and to quantitatively determine optimal policy.