Signaling Through Public Enforcement: The Example of Antitrust

Signaling Through Public Enforcement: The Example of Antitrust Salem Saljanin and Alexander Steinmetz March 19, 2013 Abstract We offer a new rationale for public enforcement. Because public enforcement is costly to governments, a government s involvement in enforcement of laws provides a message about its commitment. For example, governments can signal their support for competition through public antitrust enforcement. Governments are able to signal their commitment to the rule of law through public enforcement even if this enforcement is completely unproductive. Keywords: Private and public enforcement, antitrust, signaling. JEL classification: L40, H11, H41, K21, D82. University of Hamburg, Institute for Risk and Insurance, e-mail: saljanin@hzv-uhh.de, Phone: +49 40 42838 4043, Fax: +49 40 42838 5505. Monopolkommission, Heilsbachstrasse 16, 53123 Bonn, Germany. e-mail: Alexander.Steinmetz@Monopolkommission.bund.de. Phone: +49/228/338882-40. Fax: +49/228/338882-33 1

1 Introduction Laws have to be enforced. This can be done by private or public agents. The rationale for private enforcement is clear: private agents have obvious incentives to enforce their rights. In contrast, the case for public enforcement is generally not straightforward. This fact poses the question: Why is there public enforcement of law and why is it so widespread? At least since the seminal papers of Becker (1968) and Stigler (1970), economists recognized that law enforcement poses a genuine economic problem, especially the mode of enforcement. There is a growing literature on the relative benefits of private and public enforcement. Becker and Stigler (1974) argued for private enforcement of law in order to improve the quality of enforcement. The subsequent literature, in contrast, offers several reasons for public enforcement. Landes and Posner (1975) argued that private enforcement could lead to over-enforcement. Polinsky (1980) analyzed the role of costs differences between public and private enforcement. He concluded that incentives of private agents often lead to less enforcement. Polinsky and Shavell (2000) offer further arguments for public enforcement in their survey of the literature on public enforcement of law. One could argue that private agents should not be allowed to use force. In addition, when victims do not know who injured them or when identifying (or apprehending) violators is difficult, it may be desirable to have public enforcement. Further, there may be a natural monopoly in enforcement. Altogether, the existing literature does not provide a general and simple argument for why there is a need for significant public enforcement in so many areas of law. In other words, there are no cogent arguments for a general market failure in enforcement. We offer a new rationale for enforcement by public entities. Our approach models public enforcement as a signal by the government. By incurring enforcement costs, governments can convey their commitment to the rule of law. Why is that important? The effectiveness of laws depends on much more than the existence of legal codes it relies on a set of institutions that support the spirit of the law, especially a committed government. Governments affect social interactions in a variety of direct and indirect ways. Additionally, governments can radically change the legal and institutional framework for individual agents. However, their 2

commitment to the rule of law is not clear for at least four reasons. First, governments have difficulties in committing to future policies. Second, governments and office holders change frequently which restricts or even eliminates the possibility of building reputation. Third, individuals and groups often engage in some form of rent-seeking activities, implying that other agents may doubt the government s commitment to the rule of law. Finally, public entities may be engaged in some form of rivalry with private entities (e.g., firms in state ownership compete with private firms), implying that incentives may be unclear. Thus, it is not easy to distinguish governments that are truly committed to the implementation of laws from those that merely claim to be but are really wolves in sheep s clothing. Governments may thus need to signal their commitment. In order to be credible, the signal must be (highly) visible and costly. Public law enforcement represents such a signal of being truly committed tothe implementation of laws. The main virtue of our approach is that it is both general (i.e., it is not restricted to a certain area of law) and explains even totally ineffective public enforcement. The remainder of the paper is organized as follows. We illustrate our basic idea in more detail in the area of antitrust in section 2. Section 3 presents the basic model with unproductive public enforcement. We discuss some extensions of the basic model in section 4, especially the case with productive public enforcement that even strengthens our results. A short conclusion follows. 2 The Example of Antitrust Let us illustrate our argument in more detail in the area of antitrust. Parts of modern antitrust legislation in the United States are over 120 years old (for a historical overview of the antitrust policy in the United States, see Kovacic and Shapiro (2000)). Antitrust law is seen as a fundamental element of the basic rules of a market economy. The number of states with (serious) antitrust legislation and enforcement is continuously increasing. Further, it is getting more complex over time (for a discussion of this topic and its consequences, see Baye and Wright (2011)). Various aspects are, however, still controversial among economists. One 3

of the most prominent issues in the debate concerns the role of the public sector. Legislators can pursue two basic strategies to deter anti-competitive behavior of market participants: the creation of conditions that facilitate private enforcement through litigation by private parties, and enforcement by public entities (e.g., an enforcement agency). In fact, in most countries a combination of both approaches is taken. Private antitrust enforcement is more prevalent in common law jurisdictions like the United States or (to a smaller degree in) the United Kingdom while public enforcement dominates in civil law countries like continental Europe (see Canenbley and Steinvorth (2011) and Segal and Whinston (2006)). However, the most prominent antitrust cases, both in the United States and the European Union, are due to public enforcement although the great majority of cases in the U.S. are initiated by private parties. Further, there is no indication for a lesser role for public enforcement in the future. In particular, private enforcement of EU antitrust rules is seen as a complement to strong public enforcement by the European Commission and national antitrust authorities (see European Commission (2008)). Private enforcement seems natural and sufficing in this area of law since antitrust violations are generally difficult to conceal or even common knowledge in the given sector, these violations are no victimless crimes, and identifying violators is not hard. Additionally, antitrust enforcement is not based on a technology that leads to a natural monopoly. Further, public antitrust enforcement requires significant expenditures by governments. This raises the question: Why do we need public antitrust enforcement? Although public antitrust enforcement is so common, research on its necessity is very scarce. The existence of both private and public antitrust enforcement is generally taken as given; the existing literature has focused on the comparison between private and public antitrust enforcement (for a thorough overview, see Segal and Whinston (2006)). At first glance one could argue that public enforcers may have superior knowledge compared to private agents. That may be true for some kinds of antitrust violations, but it is generally not the case that public enforcers are better informed; private parties have in principle more (relevant) information. But even superior information in some cases does not justify public enforcement on the whole spectrum of antitrust violations. Further, private agents may have 4

other incentives than public enforcers. A firm may use an antitrust suit for strategic reasons (see Baumol and Ordover (1985) and McAfee et al. (2008)), or the option to sue may have positive strategic effects (see Schwartz and Wickelgren (2011)). This may lead to a socially inefficient level of litigation. It is clear that the extent to which firms strategically (ab)use the antitrust laws depends on the structure of damage awards in private antitrust cases. Besides the fact that public enforcers do not necessarily aim at maximizing social welfare, strategic incentives do not justify public enforcement since other and less costly instruments are available. For example, the legislator could decouple the monetary penalty to the violator and the award to the plaintiff (see Polinsky and Chee (1991)). There are also other instruments available (see, e.g., Kaplow (1993)). In addition, Posner (2001) on pages 274 and 275 has alluded to several possible reasons for the existence of public antitrust enforcement. Besides potential information asymmetries favoring antitrust authorities, he has argued that in some cases individual damages of a violation are too small to generate incentives for litigation although aggregate harm is serious. Posner argues that aggregation of small claims might not always be possible. More general, existence of public enforcement can be justified as enforcement externalities arise within private litigation systems when not just one but many private parties can engage in suing for the same violation of law. This may also result in undesired duplication of litigation effort or a free-rider problem (this is also the basic argument for public enforcement of Baker (2003)). However, this public-good problem does not imply the need for public enforcement. For example, the legislator could make private antitrust suits and their aggregation easier or even subsidy them. In this context, Bourjade et al. (2009) analyze the optimal design of rules for private litigation so as to enhance their role in enforcement. In contrast, our basic approach explains public antitrust enforcement using only weak assumptions allowing standard modeling. By incurring costs through public antitrust enforcement, governments can signal that they support competition. Once again, the success of market economies depends on much more than the existence of private property and markets it relies on a set of institutions that support effective competition in product, financial and labor markets, especially a market-oriented government (see Fleck (2000) and the literature cited 5

there). For example, a government may systematically discriminate against foreign firms or newcomers for various reasons (e.g. to protect national champions). As a signal of a government s commitment to competition, public antitrust enforcement may encourage (additional) investments by actual and potential (foreign) market participants. 3 The Basic Model In order to formalize the idea of public antitrust enforcement as a signaling device, we develop a simple signaling game in the tradition of Spence (1973) that allows a straightforward analysis of the issue (for a survey of the literature on signaling, see Riley (2001)). There are two players in the game. The first player is the government ( the sender ), and the second player is a manager of a firm ( the receiver ) in a given industry with an investment project in a given market. For simplicity, we do not distinguish between the manager and the shareholder of the firm, and assume that the manager serves the interests of the shareholder. The term project allows for various interpretations. For example, it may be a market entry by a new (and possibly foreign) firm that may fear an anti-competitive reaction of the incumbent, or the expansion of production capacity by an already active firm in the market. We make the plausible assumption that the project of the firm with the support of competition by government is more likely to succeed or at least continue. The manager s incomplete information on the government s preferences may generate considerable uncertainty. A supportive government may therefore benefit from signaling its type. The model features two periods. The manager can invest a fixed amount I > 0 in the first period in order to receive an amount V, with (1 + r) I if project succeeds, V = 0 otherwise. That is, the project could lead to a total loss for the investing firm. The parameter r > 0 denotes the rate of return on the project in the case of a success. A successful project has 6

an exogenous (discounted) value of W > 0 to the government. W allows for many interpretations. For example W could represent the government s increased popularity induced by a successful project. Further, W could be endogenized as a function of I and V, that is, W = f (I, V ), where W is the political-market value of I and V. No substantial additional insights, however, could be obtained from a generalization of our model along these lines. We thus restrict our attention to the case of a exogenous W. Note that we do not assume that the government is necessarily benevolent, that is, we don t assume that the government is only concerned with promoting competition. The government can be of two types: type A with prior probability 0 < α < 1, or type B with prior probability 0 < 1 α < 1, whereby the value of α is common knowledge. A type A government supports competition to a higher extent and thus will sustain business friendly and impartial policies ( the pro-competitive type ), implying a higher probability 0 < p A < 1 that the project will succeed over a type B government with 0 < p B < 1 ( the anti-competitive type ); that is, p A > p B. Informally, this assumption implies that the manager may be interested in the actual type of government, and that public antitrust enforcement is less desirable for a type B government. In a technical sense, this assumption implies that the single-crossing condition is satisfied. The government can spend a variable amount e 0 on public antitrust enforcement. For example, it can establish an antitrust agency. A strategy for the government prescribes a probability distribution over actions e for each type j {A, B}. In contrast, a strategy for the manager prescribes a probability distribution over I for each value of the signal e. The manager tries to maximize the firm s expected profits, and the government tries to maximize its expected benefits, defined in this case as the expected return from the perspective of the government minus costs induced by public enforcement. Note that public enforcement is totally unproductive in the context of this model. This extreme assumption can easily be relaxed. Its advantage here is to allow us to identify very 7

clearly the signaling role of public antitrust enforcement. We will relax this assumption in the next section. The timing of the game is as follows: 1. Nature determines the type of government (A or B), the government learns its type, and nobody else does. 2. The government decides on the level of e 0 which then becomes common knowledge. 3. Contingent upon the government s decision concerning e, the manager decides whether to invest I or not. 4. Nature determines the profitability of the project, which then becomes common knowledge and the payoffs are realized. The problem of the firm in a world of complete information is straightforward; the firm invests regardless of the type of government if the following condition holds: p j (1 + r) I > (1 + i) I, j {A, B}, (1) where i > 0 denotes the opportunity cost of capital, with r > i. The firm invests only under a type A government if the following conditions hold: p A (1 + r) I > (1 + i) I, (2) p B (1 + r)i < (1 + i) I. (3) The solution of the game with incomplete information depends upon the beliefs of the manager concerning the relationship between the observable signal e and the unobservable type of the government. Such beliefs are described by the following probability function µ (e) := P r {government is of type A e}, which gives the probability that the firm assigns to the government s having type A, conditional on observing the choice of e. 8

We will restrict our attention to pure-strategy equilibria. We employ the perfect Bayesian equilibrium as the relevant equilibrium concept. Signaling models are notorious for the multiplicity of their equilibria. First, we turn our attention to the possibility of a pooling perfect Bayesian equilibrium. In a pooling equilibrium, the signal provides no information about the government s type. If the government sends the same signal independent of its type, the signal must be e = 0. A situation in which both types of government send the signal e > 0 cannot be optimal because of incentives to deviate and send the signal e = 0. The manager invests independent of the government s actual type if the following condition holds: [αp A + (1 α) p B ] (1 + r)i > (1 + i) I. (4) The following propositions specify all resulting equilibria. We begin with the pooling equilibria without public antitrust enforcement on the equilibrium path. Proposition 1. Suppose that condition (4) is satisfied, then the following beliefs and strategies constitute a pooling perfect Bayesian equilibrium: α if e = 0, 1. The manager has beliefs given by µ (e) = [0, 1] if e > 0. 2. The government chooses e = 0, regardless of its type. This means that there is no public enforcement. 3. The manager starts the project, that is, the firm invests. Proof. The proof is straightforward. There is another type of pooling equilibria without public antitrust enforcement on the equilibrium path, as specified in the following proposition. Proposition 2. Suppose that conditions (4) and (2) are not satisfied, implying that condition (3) holds, then the following beliefs and strategies constitute a pooling perfect Bayesian equilibrium: 9

α if e = 0, 1. The manager has beliefs given by µ (e) = [0, 1] if e > 0. 2. The government chooses e = 0, regardless of its type. In other words, this means that there is no public enforcement. 3. The manager does not start the project, that is, the firm does not invest. Proof. The proof is straightforward. To arrive at a separating equilibrium, the government s action must fully reveal its type. The following proposition describes separating equilibria with public antitrust enforcement on the equilibrium path. Proposition 3. Suppose that condition (4) is not satisfied, and the condition (2) holds, implying that (3) holds, then the following beliefs and strategies constitute a separating perfect Bayesian equilibrium. 1 if e e, 1. The firm has beliefs given by µ (e) = 0 if e < e. 2. The government chooses e [p B W, p A W ] in the case of a type A government, and the government chooses e = 0 in the case of a type B government. 3. The manager starts the project if e e. Proof. Take the beliefs of the firm as given. Then the action e = 0 is type B s best reply, since type B cannot raise the payoff by choosing any other e. Similar reasoning applies to type A government. The condition for a type A government to prefer committing e over not committing is p A W e 0. (5) Therefore, the maximum commitment the type A government would make is e = p A W. 10

A type B government prefers no commitment over committing to spend at least e if p B W e 0. (6) The last expression is satisfied as an equality if e = p B W. Hence, e [p B W, p A W ]. Take the equilibrium strategies of the firm and the government as given. Since type B chooses e = 0 and type A chooses e = e, the beliefs are self-fulfilling. Since the threshold level e can assume any level between p B W and p A W, there is an infinite number of separating equilibria. However, since governments and firms have no benefit from raising costs, these equilibria can be ranked by the Pareto criterion. Hence, the unique efficient separating equilibrium is obtained by e = p B W. As in all standard signaling games with two types, this is also the only equilibrium that satisfies various refinements (see Cho and Kreps (1987) and Cho and Sobel (1990)). The last proposition provides a rationale for public antitrust enforcement even if it is completely unproductive. Governments use public enforcement to signal their support of competition. This may be crucial for various actual and potential market participants in order to induce them to start or expand their engagement in the market. 4 Extensions The simple model in the previous section highlights public enforcement as an unproductive signal of the government s type, designed to induce the firm to invest, to the benefit of the government. There is a variety of ways in which the analysis can be straightforwardly extended. Here we mention just two simple extensions. 4.1 Productive Enforcement The previous section highlighted public enforcement as an unproductive signal of the governments s type, designed to induce the firm to invest. It is clear, however, that at least a fraction of the enforcement effort may be productive. It is straightforward to incorporate 11

that factor in ou model. We assume in this sunsection that the success probability of the project is an increasing function of by public enforcement, that is, dp j de > 0, j {A, B}. For example, the project of the firm may be an antitrust suit. The success probability will be higher with the support of the government in form of public antitrust enforcement. Obviously, this extension strengthens our central result by making the agent even more willing to invest after observing the establishment of an antitrust authority, and so increasing the government s expected benefits. 4.2 Varying Valuations of Governments Our model can also be extended, and the effects strengthened, if governments can differ in their valuations of the project, that is, if the two types differ in the value of W. For example, this may be due to ideological differences or varying discount rates. Suppose a type A government places a value of W A and a type B places a value of W B, with W A > W B. It is straightforward to show that this plausible modification makes the case for public enforcement as a signal stronger. 4.3 Private Enforcement The model in the previous section highlights only public enforcement. The case for public enforcement as a signal to private agents becomes even stronger when we allow to a certain extend for private enforcement. This factor is especially relevant in the area of antitrust enforcement; it heavily relies on actions and information by direct competitors. The most straightforward way to incorporate private enforcement into our model is to consider the possibility that the project of the firm might be an antitrust lawsuit. It is natural to assume that the success probability of the lawsuit is higher in the case of a pro-competitive 12

government, implying that the firm might only engage in private enforcement with such a government. 5 Conclusion This paper offers a novel and general explanation for why there is public enforcement. Governments employ public enforcement as a signal of their commitment to various economic agents. Signaling commitment through public enforcement may encourage economic agents to start or continue their engagement in various activities even in the case of totally unproductive public antitrust enforcement. There are several directions in which to extend the research in our paper. The first is to enrich the analysis with a full-fledged model of the interaction between enforcement entities and economic agents. The second, related extension is to construct a much richer political economy framework. On the empirical side, there is a need for more micro-level evidence to test the effects of public enforcement predicted by the model. 13

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