Rule versus Discretion: Regulatory Uncertainty, Firm Investment, and Bureaucratic Organization

Abstract

As markets evolve, new regulatory concerns emerge. In response, policy makers institute new requirements for private businesses. Because they impose costs and generate uncertainty, these requirements may deter firm investment. To reduce regulatory uncertainty and favor investment, a principal can choose a rule-based regulatory framework. However, unlike discretion, rules do not adapt to circumstances and are thus inefficient. Using a micro-founded model, we uncover circumstances under which the ex ante certainty provided by a rule dominates the ex post efficiency provided by delegation to an unbiased agent. We also establish when delegating to a biased agent is optimal for a policy maker. Our main results highlight that the anticipated economic responses of firms can indirectly influence the organization of the bureaucracy. As such, any attempt to evaluate firms’ direct influence in the rule-making process—through lobbying or information disclosure—needs to establish the proper counterfactual that account...