Monday, January 23, 2012

Do Regulators Overestimate the Costs of Regulation?
Abstract: It has occasionally been asserted that regulators typically overestimate the costs of the regulations they impose. A number of arguments have been proposed for why this might be the case, with the most widely credited one being that regulators fail sufficiently to appreciate the effects of innovation in reducing regulatory compliance costs. Most existing studies have found that regulators are more likely to over- than to underestimate costs. Moreover, the ratio of ex ante estimates of compliance costs to ex post estimates of the same costs is generally greater than one. In this paper I argue that neither piece of evidence necessarily demonstrates that ex ante estimates are biased. There are several reasons to suppose that the distribution of compliance costs would be skewed, so that the median of the distribution would lie below the mean. It is not surprising, then, that most estimates would prove to be too high. Moreover, we would expect from a simple application of Jensen’s inequality that the expected ratio of ex ante to ex post compliance costs would be greater than one. In this paper I propose a regression-based test of the bias of ex ante compliance cost estimates, and cannot reject the hypothesis that estimates are unbiased. Despite the existence of a number of papers reporting ex ante and ex post compliance cost estimates, it is surprisingly difficult to get a large sample of such comparisons. My most salient finding does not concern the bias of ex ante cost estimates so much as their inaccuracy and the continuing paucity of careful studies.
A very thorough comparison of ex ante to ex post estimates of costs was conducted in 2000 by Winston Harrington, Richard Morgenstern, and Peter Nelson. The researchers considered 28 regulations written by EPA, OSHA, and a handful of other regional and international regulators. A number of different industries were covered. Ex ante cost estimates were considered “accurate” if they were within ± 25% of ex post values, and either too high or too low if they fell outside this range. By this standard total costs of regulation were overestimated in 15 instances, underestimated in only three, and deemed reasonably accurate in the remaining 11.
The next major retrospective study of the costs of regulation was completed in 2005 by the Office of Management and Budget (OMB 2005). OMB reviewed 47 regulations initiated between 1976 and 1995. EPA issued 18 of the regulations in the OMB sample, the most of any of the five federal agencies included in the study (the others were the National Occupational Safety and Health Administration (13 regulations included), the National Highway Traffic Safety Administration (8), the Department of Energy (6) and the Nuclear Regulatory Commission (2)). As is generally the case with estimates of regulatory costs, the sample was determined by the availability of data, not by any attempt to generate a random cross-section of regulatory activity. The results of the OMB study are less striking than those of some other researchers. Of 40 regulations for which comparable ex ante and ex post data are available, 16 ex ante projections overestimated cost, 12 underestimated them, and 12 were approximately accurate. The OMB study was not completely independent of earlier work, however: for instance, nine of the studies in its sample were adopted from Harrington, et al. 2000.

At least three studies have been conducted of the accuracy of ex ante cost measures in other countries (in addition, Harrington et al. 2000 includes three examples drawn from Singapore, Norway, and Canada among their 28 case studies). While such inquiries obviously consider costs generated under different legal and regulatory structures than prevail in the U. S., they may still be useful in interpreting general approaches to regulatory cost estimation. It might also be noted in passing that international standards for the analysis of regulatory impacts have become more similar over time, with the United Kingdom (MacLeod, et al., 2006) and the European Union adopting such requirements.5 A study conducted by the Stockholm Environmental Institute considered the cost estimates presented by industry in regulatory negotiations, and found them to be consistently higher than ex post realizations of actual costs (Bailey, et al., 2002).

MacLeod, et al. (2006) performed a similar analysis of ex ante costs in UK rulemaking. The authors of this study adopted the same ± 25% standard as used in Harrington, et al., 2000, and found that by this standard the costs of five of eight regulations considered were overestimated, those of two regulations were underestimated, and those of one were approximately on target.

In 2006 Oosterhuis, et al. published their estimates of ex ante and ex post costs of regulation with five EU environmental regulations. They report that in four instances ex ante cost estimates exceeded ex post costs by a factor of two or more, while the ex ante and ex post
We will conclude this section with summaries of two studies that considered the accuracy of ex ante cost predictions for specific consumer products. Anderson and Sherwood (2002) compare cost estimates for EPA mobile source rules. These include six fuel-quality regulations and eleven vehicle emission standards. In most instances Anderson and Sherwood found that ex ante estimates of price increases induced by regulation were greater than actual price changes observed. They also found, however, that EPA estimates tended to be closer to actual price changes than were industry estimates.

Dale, et al. (2009) considered the costs associated with the Department of Energy’s efficiency regulations on consumer appliances such as air conditioners, refrigerators, and washing machines. This study illustrates the challenges inherent in developing estimates for the costs of regulation for consumer goods. Dale, et al. derived their ex post cost estimates using hedonic regressions to tease out the separate effects of scale, general technological progress, and more competitive behavior from those of the energy efficiency regulations themselves. Having isolated these effects, the authors found, as have the other studies, that ex ante cost estimates generally exceed those developed ex post.
The studies we have reviewed uniformly find that regulators overestimate the costs of regulatory compliance more often than they underestimate them, and that the ratio of ex ante to ex post compliance cost estimates is, on average, considerably greater than one. While this might seem at first blush to establish that regulators’ ex ante estimates of the costs of regulatory compliance are biased upward, this assertion does not actually withstand closer scrutiny. I consider the two types of evidence in turn, and show that neither necessarily reveals a bias in estimates.
by David Simpson
U.S. Environmental Protection Agency (EPA) National Center for Environmental Economics
Paper Number: 2011-07; Document Date: 12/22/2011
Keywords: benefit-cost analysis; cost estimation; ex ante; ex post; innovation; iterated expectations; Costs of Pollution Control; Benefit-Cost Analysis

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