The Schumpeterian Cost of Regulation on Entry and Innovation:
The Case of Bail Bonds
Erin L Scott
National University of Singapore
Anne Marie Knott
Washington University in St. Louis
November 22, 2013
These results are preliminary. Please do not cite or quote without permission
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Special thanks to members of the Professional Bail Agents of the United States for sharing their time and industry insights. This paper benefits from comments from seminar participants at Washington University in St. Louis, CCC at Massachusetts Institute of Technology, the Entrepreneurship/Innovation Seminar at UCLA, the Oliver E. Williamson Seminar on Institutional Analysis at UC Berkeley, the TIES seminar at Massachusetts Institute of Technology, the Atlanta Competitive Advantage Conference, AB Freeman School at Tulane, the ARISE workshop at the National University of Singapore and the strategy seminar at HEC Paris. This research was funded in part by the Ewing Marion Kauffman Foundation. All errors remain the authors.
The Schumpeterian Cost of Regulation on Entry and Innovation:
The Case of Bail Bonds
Entrepreneurship is valued in part because it stimulates Schumpeter’s gale of creative destruction. A popular view, reinforced by recent empirical work on regulatory reform, is that regulation inhibits entrepreneurship and innovation. However dismantling regulation is ill-advised, since generally regulation has primary goals other than to increase innovation. We study the impact of regulation on entry and innovation in such a setting, the bail bond industry. We build structural models of the entrepreneur’s entry decision and the incumbent’s continuation decision, then employ recovered parameter estimates in counterfactual policy environments that allow us to compare the impact of different regulatory regimes. Results from this exercise indicate that a combination of entry and operating regulations reduces entry yet increases innovation relative to a setting with no regulation. These benefits are above and beyond the intended benefits of theregulations. Our results suggest it is possible to design regulations without imposing the Schumpeterian cost on innovation, and provide preliminary indications of how to accomplish this. Moreover our results suggest that Schumpeterian cost itselfmay need to be redefined. Entry and innovation actually oppose one another in our setting. Not only does excess entry steal share, in so doing it also suppresses incentives to innovate.
1.Introduction
Entrepreneurship is valued in part because it stimulates Schumpeter’s gale of creative destruction. In addition to bringing forth “the new commodity, the new technology, the new source of supply, the new type of organization” (Schumpeter 1947: 84), entrepreneurial entry “strikes…existing firms…at their foundations and their very lives” and thereby triggers two forms of incumbent response: an immediate response of lowering prices, and often a lagged response of strategic investment to reduce cost and escape competition (Aghion et al, 2001). It is these strategic investments by incumbent firms to escape competition, in addition to the direct actions of entrepreneurs, wherein innovation occurs.
One factor shown to affect the level of entrepreneurship is the administrative cost of entry imposed by governments. In a 2002 study, Djankov et al characterized the administrative entry costs to start a business across 85 countries (including both direct payments and time spent complying with procedures). The study revealed dramatic differences between entry costs (expressed as percentages of per capita income) in the US (0.017) versus Europe (0.35 to 0.40) as well as other countries. In addition, the study indicated that countries with lower entry costs had higher entry rates as well as higher productivity, as the Schumpeterian gale anticipates. The Djankov entry cost data were subsequently employed in a number of studies to further examine the basic findings. These studies revealed that entry costs had a significant detrimental impact on entry rates (Fisman and Sarria-Alende 2004, Klapper Laevan and Rajan 2006, Cicone and Papaioanno 2007, Dreher and Gassebner 2007) as well as total factor productivity (TFP) (Nicolettti and Scarpetta 2003, Fisman and Sarria-Alende 2004, Loayza Oviedo Serven 2005, Barseghyan 2008).
Not surprisingly, these findings stimulated widespread policy reforms to simplify business startup: 193 reforms across 116 countries (World Bank 2008). The reforms in turn fueled a second wave of empirical analysesemployingnew natural experiments with varied entry costs and administrative procedures. The second wave of empirics largely corroborated the results from the initial wave. Studies of SARE (Expedite Business Startup System-- a federal government program allowing startups to open operations within one business day of application) in Mexico indicated that the startup rate (new entry as a percentage of the number of incumbent firms) increased four to five percentage points after the introduction of a more simplified, expedited new business registration system (Kaplan, Piedra, Siera 2007 and Bruhn 2008). In addition, theSARE studies found that the increased entry rate was associated with increased job creation (Kaplan et al 2007) as well as decreased prices (Bruhn 2008). Similar results were found for reforms in Brazil (Monteiro and Assuncao 2006), Russia (Yakovlev and Zhuravskaya 2007) and India (Chari 2007). Moreover, these results were consistent with prior studies of US deregulation, such as Olley and Pakes (1996) who found that telecommunications deregulation stimulated significant entry, which in turn generated the downsizing and shutdown of unproductive plants resulting in substantial increases in productivity growth. These studies have been used to reinforce the popular view that regulation is counter to entry and innovation, expressed in political rhetoric, as well as in many policies proposed in response to the economic downturn[1].
Despite the apparent consensus regarding the relationship between entry costs and innovation, entry regulations have been pervasive, as the first order concerns of regulations are rarely innovation. Regulations are designed, among other reasons, to correct market failures, protect regional interests, and contribute to the moral aspirations of a society (e.g reduce discrimination, enforce language laws). When designing regulations for these first order concerns, policymakers are, and should be, concerned about their impact on innovation. However, the literatureoffers little indication as to theimpact of different types of regulations on entry and innovation. This is because prior empirical work has either looked at the impact of a specific regulation(Thomas 1990) or, more commonly, has employed measures of regulatory extent – such as the strength of relevant political parties (Bertrand and Kramarz 2002), number of entry procedures (Klapper Laeven Rajan 2006; Djankov 2002), length of the relevant administrative code, or the size of the respective regulatory agency budget (Dudley and Warren 2010) – rather than the nature of the specific regulations themselves. While these measures of regulatory extent were extremely valuable in allowing researchers to compare the impact of administrative costs on entry and productivity, a naturalnext stepis examining the impact of a broader set of regulations.
Since industry regulation is rarely monolithic, there may be opportunity to choose from a menu of regulations in an effort to preserve the first-order goals of regulation while minimizing the Schumpeterian costs of regulation (reduced innovation). Indeed, most regulated settings already comprise multiple regulations including entry restrictions and/or operating restrictions. Entry restrictions and operating restrictions differ in their impact on entrant and incumbent behavior. Operating regulations typically mandate specific firm behavior, such as minimum product quality. For example, in the child-care industry regulations include a minimum staff-child ratio (Hotz and Xiao 2011). Accordingly, one concern with operating regulations is they may limit firms’ ability to differentiate themselves. An additional concern is that regulatory mandates may be driven by current processes and/or technologies and, as a result, may limit firms’ability to innovate or respond to future changes within the industry.
In contrast, entry regulations set no mandate for firm behavior. Rather they achieve their goals by screening potential entrants based on human and/or physical capital requirements. For instance, state banking commissions typically require potential entrants to have extensive industry experience as well as invested capital in excess of a million dollars in order to enter. Entry regulations such as these may allow for maximum flexibility in incumbent decision-making when compared to operating regulations. However, by increasing the size and capital requirements for entrepreneurs there is concern these regulations may indiscriminately screen out small, young firms (Klapper, Laeven, Rajan 2006). Furthermore, by restricting the pool of potential entrants, such regulation may deter competition and affect incumbent incentives to innovate (Posner 1975, Peltzman 1978, Stigler 1971).
Different regulatory frameworks may also provide perverse incentives to manipulate the regulations to the benefit of regulatory agencies at the detriment of society. Indeed, the high economic costs to regulation found in the previous literature may be due in part to regulatory capture, rather than a consequence of entry regulations themselves. For example, the administrative costs from the Djankov (2002) data tend to be highly correlated with the country corruption indices (Fisman and Sarria-Allende 2004). Regulatory“capture”occurs when regulation is usedas an instrument for generating rents for those controlling the regulation, be they incumbents (Stigler 1971) or politicians (Schliefer and Vishny 1993). Regulatory capture is possible becausethe diffuse incentives of outside individuals to fight regulations are swamped by the financial incentives of the captured parties to pursue particular regulations. This view is orthogonal to the traditional “Pigovian” view of regulation. Under the Pigovian view, regulation is a policy tool to correct market failures arising from inherent characteristics of an industry such as public goods, externalities, natural monopolies, or information asymmetries (Pigou, 1938). Regulations in these contexts attempt to correct the failures by internalizing externalities, controlling monopolists, or providing the public with improved information (Dudley, 2005).
The empirical record provides considerable support for both regulatory views, with most regulations likely being initiated for market correction purposes and ultimately yielding some regulatory capture. When regulation is primarily of the capture form, it is not surprising that deregulation produces the entry and productivity benefits seen in the reform studies. In these instances, deregulation is merely removing another market imperfection. Therefore, while the consensus in the literature may be that entry regulation substantially constrains productivity growth, this may not be borne out to the same extent in settings with less regulatory capture. Moreover, understanding the relative performance of different regulations with respect to their impact on entry and innovation may not only allow policymakers to make more informed decisions regarding the Schumpeterian costs of their regulations, but may also allow for a more accurate assessment of the degree of regulatory capture induced by different regulations[AK1].
To study the Schumpeterian cost of regulation we have assembled data on demand, firms, and regulations across fifty-two markets and twenty state regulatory environments for the United States Bail Bond Industry between 1990 and 2004. The United States bail bond industry has natural quasi-experimental properties that make it ideal for studyingthe Schumpeterian cost of regulation. The industry comprises roughly 14,000 owner-managed firms in over 3,000 discrete markets (county courthouses) that differ in demand (demographics and crime rates), entry costs and restrictions (through entry regulations), as well as profitability per defendant (through operating regulations). Furthermore, there are measures of market productivity and innovation that are comparable across markets and with time. Finally, there is substantial industry churn: new firms enter each year at a mean rate of 20% of the incumbent population (versus 10% within the economy generally). Thus the setting presents an unusually sensitive test of entrepreneurial response to differences/changes in market conditions (including regulations).
Our approach to examining the cost of regulation on entry and innovation utilizes structural models of the entrepreneur’s entry decision and the incumbent’s continuation (not to exit) decision. These models allow us to recover parameter cost estimates for specific regulations. We then employ these parameter estimates in simulated firm decisions for unobserved regulatory regimes in a representative market over several periods. The aggregation of entrant and incumbent decisions over these periods generates evolutions in market structure and productivity for the representative market. These counterfactual policy simulations allow us to better understand the extent to which differences in entry and innovationare driven by differences in regulation.
Results from this exercise indicate thata combination of entry and operating regulations reduces the equilibrium number of firms, yet increasesinnovation relative to a setting with no regulation. More specifically, the analysis reveals that regulations affecting firm self-selection (such as entry or continuation fees) increase innovationwhereas operating regulations circumscribing firm behavior have no impact on firm entry or innovation. The innovation benefits of these regulations are assumed above and beyond their intended benefits in this setting (prohibiting transaction inequities and rights abuses). These results suggest it is possible to designregulations without imposing Schumpeterian cost on innovation. They also provide preliminary clues as to which regulations best accomplish this goal. Finally, and perhaps most importantly our results suggest that Schumpeterian cost itself may need to be redefined. Entry and innovation actually oppose one another in our setting. Not only does excess entry steal share, in so doing it also suppresses incentives to innovate.
2.Setting: The US Bail Bond Industry
2.1 Introduction
Bail is a financial system for providing defendants freedom prior to trial while simultaneously attempting to ensure their appearance at trial. The court holds the bail amount in exchange for pre-trial release of the defendant. If the defendant appears at trial, the full bail amount is returned to the defendant regardless of trial outcome. If the defendant fails to appear at trial however, the court retains the full bail amount and issues an arrest warrant for the defendant. Surety bonds (the bail bond industry) are a market mechanism for meeting bail in which a bail agent posts a surety bond with the court on behalf of a defendant. The defendant pays the agent a non-recoverable fee (typically 10% of the bail) and also provides collateral for the bond (from 25% to 200% of the bail). The agent is then liable for the bail amount if the defendant fails to appear (FTA) at court, and so agents have considerable rights to monitor and apprehend their defendants.
There is substantial debate about the relative merits of public enforcement versus private enforcement (bail bonds) of pre-trial release. Despite concerns the industry is tainted by corrupt and/or strong arm tactics, past economic studies of bail have indicated that private enforcement offers many social advantages over public enforcement. In particular, competition among bail bond agents yields bond fees that partially compensate for judicial discrimination in bail setting (Ayres and Waldfogel 1994). In addition, private enforcement reduces FTA and fugitive rates relative to public enforcement. After matching defendants on inherent flight risk, FTA rates are 23% lower and fugitive rates are 46% lower for defendants on surety bonds (private enforcement) versus deposit bonds (public enforcement)(Helland & Tabarrok 2004). These lower FTA and fugitive rates and their associated police and court costs translate into estimated public savings of 63% per pre-trial release defendant for private enforcement relative to public enforcement (Block and Twist, 1997). Accordingly, the bail bond industry offers benefit toits customers(defendants) throughrelease, and to communities through decreased FTA and fugitive rates.
2.2 Bail Contracts
Figure 1 outlines a typical bail transaction. Once a person is arrested, he or she must be arraigned within thirty-six hours. The purpose of the arraignment is to file formal charges against the defendant and to establish the terms of pre-trial release. In approximately 45% of cases defendants are released without up-front cost (called non-financial release). Bail agents only become relevant in cases where the court sets a bail, does not allow bail to be satisfied through an unsecured bond, and where the defendants cannot raise bail on their own (roughly 21% of cases).
Defendantswho wish to be released, but who cannot raise the full bail amount, select bail agents either from a list of all agents maintained at the jail,from the yellow pages, or more recently, from online advertisements. Historically yellow page ads havebeen the primary form of advertising and the largest fixed expense of bail agencies.
From the perspective of the defendants, the service bail bond agents provide is undifferentiated. Price competition in this industry occurs through the defendants (or persons on their behalf) calling several agents to find the lowest commission fee and/or collateral requirements given the defendant’ history, charges, and bail amounts. Evidence of such price competition comes from Ayres and Waldfogel (1994) who show competitivemarkets exhibit lower commission fees.