LawFin Research Seminar joint with Finance Seminar

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.