Answers - Reading 7 Economics of Regulation

Question #1 of 17 Question ID: 1472323 The requirement for firms to carry out an annual independent audit is best described as a regulation implemented to address: A) sub-optimal allocation of resources. B) information asymmetry. C) externalities. Explanation Management have greater knowledge than investors, a situation known as informational asymmetry which the independent audit seeks to address. Audits promote high quality financial reporting, which reduces the information asymmetry between management and investors. Externalities are costs and benefits affecting a party that did not choose to incur that cost or benefit. Externalities often lead to sub-optimal production decisions. (Module 7.1, LOS 7.a) Question #2 of 17 Question ID: 1472331 To combat childhood obesity, the city of San Francisco, CA banned fast food restaurants to bundle free toys with kids menu choices deemed unhealthy. The restaurants simply allowed customers an option to purchase toys at an insignificant cost in lieu of including it free. This is an example of: A) Regulatory arbitrage B) Regulatory failure C) Regulatory capture Explanation Regulatory arbitrage occurs when the firms exploit the difference between the economic substance and interpretation of a regulation. Regulatory capture occurs when the regulatory body gets influenced (or even controlled) by the regulated industry. Regulatory failure is not defined in the curriculum. (Module 7.1, LOS 7.f) Question #3 of 17 Question ID: 1472329 Self regulating bodies that are recognized by the government and are given regulatory powers: A) may be susceptible to political pressures from members. B) are common in civil law countries. C) are less effective in carrying out regulatory objectives than are governmental agencies. Explanation SROs are SRBs that are given recognition and regulatory powers. SROs may be still subject to political pressure from their members. SROs when properly supervised by regulatory agencies have been effective in carrying out the objectives of the regulation and use of SROs in civil-law countries is not common. (Module 7.1, LOS 7.f) Question #4 of 17 Question ID: 1472330 Which of the following statements regarding self-regulating bodies is least accurate? A) B) Self-regulatory bodies are private organizations that both represent and regulate their members. FINRA in the U.S. is an example of a self-regulating organization in the financial markets. C) Self-regulating bodies are recognized by the government. Explanation Not all self-regulating bodies are regulators: SRBs are only regulators if they receive government recognition. In some countries, SRBs are never recognized by the government. Self-regulating organizations (SROs) differ from standard self-regulatory bodies in that SROs are given recognition and authority by a government body or agency. FINRA is an example of a self-regulating organizations (SROs); its purpose is to ensure that the securities industry operates fairly. (Module 7.1, LOS 7.f) Question #5 of 17 Question ID: 1472337 Maldovia, an emerging market country in Latin America has joined a trade alliance. To comply with the terms of the alliance, Maldovian government is reducing farm subsidies and increasing taxes on environmentally unfriendly business practices in industrial waste treatment and mining industries. Due to these changes, which Maldovian industries are least likely to shrink: A) Airline B) Mining C) Food processing Explanation Reduction in subsidy would shrink food processors as their costs increase. Mining industry would shrink due to additional taxes. Airline industry would be relatively unaffected by new regulations (nothing in the question suggests impact on airline industry). (Module 7.1, LOS 7.i) Question #6 of 17 Question ID: 1472322 Regulations are least likely needed under which of the following situations: A) B) C) A small investor is investigating a speculative stock and applies an incorrect growth estimate for the company’s earnings. A small town is experiencing large inflow of out-of- town visitors constraining street parking. A small privately-held developing ‘Apps’ seeks equity investors to finance development of additional software. Explanation Regulations are needed in the presence of information asymmetry externalities, weak competition, and social objectives. A privately held company seeking new equity investors would be in a situation where the company insiders have better quality information than the investors (i.e., information asymmetry). Street parking is a public good (i.e., an externality) which needs to be regulated for its optimal production and allocation. Incorrect growth estimates are subjective and not due to information asymmetry and hence would not be a valid justification for regulations. (Module 7.1, LOS 7.a) Q estion #7 of 17 Question #7 of 17 Question ID: 1472328 Gordon Futona is evaluating the regulatory burden faced by a company he follows as an equity analyst. Futona makes the following two statements: Statement 1 Statement 2 Prudential supervision is a regulatory tool governments may use to limit potential financial contagion. Antitrust regulation may prevent two companies from merging, but has no power over the pricing policies of firms. Which of Futona's statement(s) are correct? A) Statement 2 only. B) Both statements are correct. C) Statement 1 only. Explanation Statement 2 is inaccurate: antitrust regulation seeks to address any anti-competitive behavior, including practices such as discriminatory pricing. Statement 1 is accurate as given. (Module 7.1, LOS 7.e) Question #8 of 17 Question ID: 1472326 A Swiss company is looking to acquire their main competitor based in Singapore. This acquisition could create a company that represents 55% of the market share. An analyst following this industry must be aware of potential anti-trust regulatory issues in: A) Switzerland. B) Singapore. C) both Singapore and Switzerland. Explanation Regulators in both countries can potentially block this acquisition. An analyst following the industry has to be aware of both countries' anti-trust regulations. (Module 7.1, LOS 7.c) Question #9 of 17 Q estion ID: 1472334 Question #9 of 17 Question ID: 1472334 Which of the following regulatory interventions is theoretically least effective? A) Subsidizing the cost of environmentally friendly projects for small firms. B) Requiring a company to pay a fine if annual financial statements are not filed in a timely fashion. C) Imposing a punitive tax on the consumption of junk food to cut its consumption. Explanation Fining the company would place the regulatory burden on the shareholders whom the regulation is intending to protect. (Module 7.1, LOS 7.g) Question #10 of 17 Question ID: 1472335 A review of an existing regulation with a sunset clause has revealed that the net regulatory burden is less than the initial estimates. A possible reason for this is that: A) indirect costs were underestimated. B) regulatory burden was underestimated. C) private benefits were underestimated. Explanation The net regulatory burden is the difference between the regulatory burden and private benefits. Prior to implementation of the regulation, a potential net regulatory burden is estimated. A sunset clause requires regulators to use actual outcomes to see if the regulation should be renewed. This is a comparison between actual and estimated values. Only when private benefits are underestimated would the actual net regulatory burden be less than the estimated. (Module 7.1, LOS 7.h) Question #11 of 17 Question ID: 1472333 Maldovia is a rapidly growing emerging market economy. To boost the level of capital per worker, the government allows for higher-than-previously allowed levels of depreciation expense for tax purposes on new equipment lowering the effective cost for the business. This is an example of: A) a price mechanism regulatory tool. B) a provision of public good/financing private project regulatory tool C) requiring certain activity regulatory tool. Explanation Tax breaks on new equipment purchases are effectively government subsidies. Taxes and subsidies are examples of price mechanism regulatory tool. (Module 7.1, LOS 7.g) Question #12 of 17 Question ID: 1472324 Which of the following is least likely to be a purpose of regulating commerce: A) Preserve integrity of stock exchanges. B) Restrict unfair competition. C) Protect domestic industries from unfair foreign competition. Explanation Protecting domestic industries and restricting unfair competition are examples of purposes of regulating commerce. Preservation of integrity of stock exchanges is an example of regulating financial markets. (Module 7.1, LOS 7.b) Question #13 of 17 Question ID: 1472336 "Net regulatory burden" is best defined as: direct costs of implementation, less private benefits resulting from A) implementation, plus the indirect cost of changes in economic behavior resulting from implementation. B) C) direct costs of implementation, less private benefits resulting from implementation. direct costs of implementation, plus the indirect cost of changes in economic behavior resulting from implementation. Explanation Instagram:- @laxmicopycenter Net regulatory burden measures direct and indirect costs against the private benefits resulting from implementation. (Module 7.1, LOS 7.h) Question #14 of 17 Question ID: 1472332 After a recent financial crisis, Ruritania and all of its neighbors except one voted to enact stringent regulations prohibiting 100% mortgage loans. (A 100% mortgage is one where the borrower receives a loan amount equal to the total value of the property.) The Ruritanian government is now concerned that firms may leave Ruritania and base themselves in a country without the stringent regulation. This situation is best described as an example of: A) regulatory arbitrage. B) regulatory burden. C) regulatory capture. Explanation When a company chooses to relocate to a new jurisdiction to avoid regulation, this is an example of regulatory arbitrage. Regulatory capture leads to regulation intended to enhance the interests of regulated entities. Regulatory burden refers to the costs of regulation for the entity being regulated. (Module 7.1, LOS 7.f) Question #15 of 17 Question ID: 1472325 Which of the following statements is most accurate regarding the regulation of security markets? A) B) C) Regulations requiring the insurance of retail deposits at large banks may increase risk-taking incentives for the bank. Most securities markets require investors to transact through intermediaries to reduce potential agency problems. Historically, regulations have focused on large investment schemes such as private equity funds, rather than on retail investors. Explanation Regulation has historically focused on the protection of retail investors. When investors work through intermediaries it introduces rather than reduces the agency problem. When bank deposits are insured, banks may adopt more aggressive risk-taking policies. (Module 7.1, LOS 7.b) Question #16 of 17 Question ID: 1472338 Regarding the impact on industry of regulation, regulation is least likely to: A) reduce inefficiencies in the industry. B) benefit the industry being regulated. C) increase the size of an industry. Explanation Regulation can increase the size of an industry, for example through the use of subsidies. Regulatory capture means that regulation can sometimes benefit the industry being regulated. However, regulation is also likely to introduce inefficiencies – such as the implicit government bailout guarantees of the financial sector which lead to credit spreads that do not fully reflect the credit risk. (Module 7.1, LOS 7.i) Question #17 of 17 Question ID: 1472327 Dan Garbutt is studying the burden of regulation that companies in Eglaria, a developing country in Europe, face. He has identified the following regulatory body that he feels places a large regulatory burden on the economy. The Independent Auditing Review Panel (IARP) The IARP is recognized, but not funded by, the government of Eglaria. Funding is via a charge added to the mandatory annual audit for all public companies operating in Eglaria. The IARP's role is to ensure that audits are carried out to a high and consistent standard, and it has the power to revoke the auditing license of any company which it feels is not up to standard. The IARP is run by a board of ten members from a wide range of backgrounds, none of whom are licensed auditors. The IARP is best described as a: A) self-regulating organization B) independent regulator C) government agency Explanation Independent regulators are not government agencies, however they are granted authority by a government and do make some regulations. The IARP is not a government agency as it not funded by the government. Nor is it a self-regulating organization as it is not an organization that regulates its own members. (Module 7.1, LOS 7.d)