The economics of penalties and the penalty of being an

economist.

(Comments inspired by Millard)

Stephen P. King.

1. Introduction
Penalties for breaches of competition laws are problematic. Firms might face punishment
through a monetary fine. Individuals might also be fined or even face imprisonment. But
do these type of penalties work?

Ian Millard, in his chapter in this volume argues that the evidence shows a failure
of harsher penalties to act as a deterrent. While much of the empirical evidence is drawn
from criminal penalties, it seems likely that a similar failure of penalties also exists for
breaches of competition law. If existing penalties do not work then, as Ian notes, it seems
incongruous to attempt to make them work by increasing them. Such an attempt
resembles a person who, when faced by a problem with a piece of mechanical equipment,
proceeds to kick it. When this fails, the person takes a sledgehammer to the machine, sure
that it will respond if given sufficient incentive.

If existing penalties are not the appropriate responses to breaches of competition

laws then, as Ian states in his conclusion, increasing these penalties as a “knee jerk
reaction” might actually “work against the very competition that the Act is intended to
promote”. Ian suggests that a better alternative might be a “properly resourced and
willing enforcement agency”.

While I agree with Ian that appropriate funding for enforcement is a key element
to effectively implement competition policy, it is not obvious that increased funding for
an enforcement body is either sensible public policy or will act as a preferred substitute to
increased penalties. Rather, the key issue that we need to address when considering
appropriate responses to breaches of competition laws is the mix of enforcement and

1
penalties, and the incentives created by that mix. Put bluntly, if higher penalties do not
work, then why do they not work?

The requirement to answer such a question, of course, is the curse of the

economists. A common joke, made at the expense of my discipline, states that economists
are people who note that something happens in reality but are not willing to believe it
until they prove it in theory. There is more than a grain of truth in this quip. If increased
fines do not work then, as an economist, I am obliged to ask why they do not work. It is
not enough to simply note the failure and suggest an alternative. After all, how can we be
certain that the alternative is better than the failed policy it replaces? The penalty of being
an economist is that, before we can suggest an appropriate alternative, we need to
understand why the existing arrangement is inappropriate.

In this chapter, I will consider the economics of penalties as applied to breaches

of competition law. In particular, why might monetary penalties imposed on firms or
executives not be appropriate remedies for competition law breaches? I then suggest
some potential alternatives that may be more appropriate.

2. The economics of penalties

Most economic analysis of penalties and remedies looks at the criminal law. The starting
point is what Garoupa refers to as the Deterrence Hypothesis.1 This is the assumption that
individuals who might be tempted to break the law will respond positively to the
perceived benefits of illegal actions and will respond negatively to the risks and penalties
associated with those actions.

This hypothesis seems reasonable for most people, most of the time. For example,
if stealing a car led to certain capture and capital punishment, then it seems likely that far
fewer cars would be stolen. Many potential car thieves will weigh up the benefits against
the high cost and decide not to steal cars. However, the assumption is not likely to hold
for all individuals and for all crimes. It is well recognized in psychology and economics

1
N. Garoupa, (1997), “The theory of optimal law enforcement”, Journal of Economic Surveys, 11,
267-295.

2
that individuals behave ‘oddly’ when dealing with small probabilities. For example, there
is a tendency to be overconfident and potential criminals might dismiss small
probabilities of detection. Similarly, some crimes are spur-of-the-moment actions and are
not rationally considered by the perpetrator. So called crimes of passion fall into this
class of behaviour. It is possible that the number of these crimes will not significantly
respond to benefits and costs.

Becker, in a seminal article, showed how the deterrence hypothesis and economic
methods could be used to analyse crime and punishment.2 Becker argued that detection
and the penalty were substitutes from a social perspective. Either raising the penalty
and/or raising the probability that the criminal will be apprehended and successfully
prosecuted, can deter crime. However, Becker noted that monetary fines, as a penalty, are
simply a transfer between members of society while detection involves the use of
significant social resources. The police and judiciary are expensive. Becker concluded,
that it is generally socially desirable to have a high penalty for criminal action and to
trade off such penalties with lower expenditure on detection and prosecution.

The result, that a maximal monetary penalty for crime is socially optimal, spurred
significant debate. Polinsky and Shavell note that imprisonment is not simply a transfer
but a costly form of punishment. If fines and prison sentences are substitute punishments
from the criminals’ perspective, then it is socially desirable to use fines rather than
incarceration as a form of penalty.3 If, however, all relevant forms of punishment are
socially costly, then it will be desirable to trade off penalty and enforcement. For
example, fines are not costless to enforce and many potential criminals will have limited
funds so that fines may not be a reasonable option for punishment. In such circumstances,

2
G. Becker, (1968), “Crime and punishment: an economic approach”, Journal of Political
Economy, 76, 168-217.
3
A. Polinsky and S. Shavell (1984), "The optimal use of fines and imprisonment", Journal of
Public Economics, 24, 89-99.

3
society needs to trade off the costs and benefits of extra enforcement and harsher
penalties.4

Using maximal monetary fines does not require the courts to have any
information about the harm created by a criminal’s actions or the benefit of the action to
the criminal. It will often be the case that the court can gain some information about the
level of harm or benefit. If the court has such information, then this can modify the
optimal penalty. For example, suppose that the court can gain a good understanding of
the harm created by a criminal act. Then the actions of the criminal, by imposing costs on
other members of society, are simply one example of what economists call externalities.

An externality arises whenever one individual takes an action that benefits or

harms another and there is no compensation paid for this action. Pollution is a simple
example. There is a significant literature on externalities in economics. One conclusion
from that literature is that social welfare can be improved by explicitly or implicitly
making the person who takes an action face the external costs or benefits of this action.
For a criminal act, this means that the criminal should face the harm that they inflict on
other members of society. As apprehension is not certain for criminal acts, the
appropriate penalty is the level of harm divided by the probability of detection and
prosecution.5

Courts might also be able to measure the benefits created by an illegal action.
Many criminal acts are always harmful to society. However, other illegal actions can be
ambiguous. This is the case with competition law. A manager might undertake an action
that potentially creates benefits as well as costs. For example, a manager embarking on a
strategy of lowering prices to predate a competitor creates benefits for consumers. On
net, these social benefits might outweigh the social costs of the attempt at predation,

4
See L. Kaplow, (1990) “A note on the optimal use of non-monetary sanctions”, Journal of Public
Economics, 42, 245-247.
5
See A. Polinsky and S. Shavell, (1992), “Enforcement costs and the optimal magnitude and
probability of fines”, Journal of Law and Economics, 35, 133-148, and S. Shavell, (1991), “Specific versus
general enforcement of law”, Journal of Political Economy, 99, 1088-1108.

4
particularly if prices do not fall below short-run marginal cost and any market power that
follows successful predation is quickly dissipated. If the court can determine both the
benefit and harm created by an illegal action then Shavell notes that the court should take
both of these into account.6 This said, the key element for determining penalties remains
the measure of harm created by the action. Shavell summarises this in the context of
liability laws.

“A central point of the economic analysis of corporate liability for harm

done to strangers (parties other than employees and customers of a
corporation) is that the level of liability should generally equal the
magnitude of harm. The rationale is 2-fold. If liable firms must pay
damages equal to harm , then first, firms will in principle be led to take
appropriate care to prevent harm; and, second, product prices will tend to
reflect the full social cost of production, inducing consumers to make
socially correct purchase decisions”.7

This conclusion holds for breaches of competition laws.

The ambiguity of laws, like the New Zealand Commerce Act, means that parties
might ‘accidentally’ breach the law. The possibility for an accidental breach might affect
the optimal penalty. This will, however, depend on the ability of the potentially offending
party to check its actions ex ante. For example, if the party can easily reorganize its
behaviour to gain the same (legitimate) benefits but without running the risk of breaching
the law, then holding the party strictly liable for its actions can be desirable.8 On the other
hand, if legitimate mistakes can be made and are unavoidable, it might be desirable to

6
S. Shavell, (1987), “The optimal use of non-monetary sanctions as a determent”, American
Economic review, 77, 584-592.
7
S. Shavell (1997) “The optimal level of corporate liability given the limited ability of
corporations to penalize their employees”, International Review of Law and Economics, 17, 203-213, at
p.203.
8
See R. Pitchford, “An economic analysis of Australian damage remedies for misleading
prospectuses: Trade Practices Act versus Corporations law”, Australian Economic Review, 31, 27-36.

5
temper the penalty, even in the strict Becker framework, to avoid deterring acts that
might be illegal but probably are legal.9

A key issue for competition policy is that the individuals directly responsible for
breaching the law are often agents of the company’s owners. It is not the shareholders
who instigate an abuse of market power or an anti-competitive merger, but rather the
directors appointed by the shareholders or the managers appointed by the directors. This
raises two important issues. First, if an employee breaches competition laws with the
intention of raising firm profits, then this does not provide a direct benefit to the
employee. The incentives for the employee to undertake the illegal activity must originate
with the employee’s superiors and, at the extreme, the CEO and directors of the
company. If an employee faces high-powered incentives based on company profits, then
they might be tempted to undertake illegal actions. Penalties should be structured so that
directors, the CEO and the shareholders take these potentially socially undesirable effects
into account when setting incentives for employees. “If firms are made strictly liable for
their harms, they will design rewards and punishments for their employees that will lead
employees to reduce the risk of causing harm”.10

Second, it might be difficult for firms to appropriately punish an employee for an

action that breaches the law. The most extreme punishment that a firm can inflict is to
dismiss an employee. If the threat of such punishment is not enough to make the
employee take care to only pursue legal actions, then it might be socially desirable to
impose penalties directly on an employee who breaches the law. In other words, while
firms need to take competition laws into account when setting employee incentive

9
L. Kaplow, (1990) “Optimal deterrence, uninformed individuals and acquiring information about
whether acts are subject to sanctions”, Journal of Law, Economics and Organization, 6, 93-128.
10
A. Polinsky and S. Shavell, (1993), “Should employees be subject to fines and imprisonment
given the existence of corporate liability?”, International Review of Law and Economics, 13, 231-257. See
also J. Gans (1999) “Incentive contracts, optimal penalties and enforcement”, Working Paper, Melbourne
Business School, Australia.

6
schemes, it might also be desirable to directly penalize employees for breaches of the
law. Society can impose penalties that are unavailable to firms.11

In summary, economic research suggests that penalties should be harm based.

There is a trade-off between penalties and enforcement with higher monetary penalties
often being preferred to greater enforcement. This said, the potential for mistakes by
either firms or courts needs to be considered when setting penalties. Further, it needs to
be recognized that breaches of competition laws often involve situations of a delegated
agent taking illegal actions that benefit the firm.

3. The New Zealand reforms

Ian Millard’s chapter summarises the proposed changes to penalties under the Commerce
Act. These include increased fines for corporations that breach the restrictive trade
practices provisions of the Act and attempts to hold individuals more directly liable for
breaches. Firm penalties can be based on three times the expected or actual gain to the
firm. While maximum individual fines are unchanged the Competition Commission can
under certain circumstances seek to have a person barred from holding a managerial
position for up to five years.

Millard notes the lack of evidence, either generally or in New Zealand, about the
effectiveness of increased penalties in deterring breaches of competition laws. While
much of the empirical evidence relates to criminal law, there have been some studies on
competition laws. There is some evidence that very high penalties might have an effect
on restrictive practices by firms. For example, Block, Nold and Sidak consider data
relating to collusive arrangements in the US bread industry.12 They conclude that
increased enforcement and the “threat of large damage awards to private class actions”

11
See Polinsky and Shavell op. cit. n.10. A similar issue is raised in other areas of the law. For
example, see R. Pitchford, (1995), “How liable should a lender be? The case of judgment proof firms and
environmental risk”, American Economic review, 69, 880-891.
12
M. Block, F. Nold and J. Sidak, (1981), “The deterrent effect of antitrust enforcement”, Journal
of Political Economy, 89, 429-445.

7
had a deterrent effect but that “government-imposed price-fixing penalties were trivial”.13
Overall, however, it appears that increased penalties by themselves are unlikely to have a
significant effect on reducing breaches of the Commerce Act.

This returns us to the original question. If higher penalties do not work, then why
do they not work? In part, the answer is suggested by the economic discussion above.
Breaches of competition laws often involve delegated decisions and ambiguous laws.
Designing appropriate penalties for such breaches needs to take these factors into
account. This leads to a number of specific proposals.

1. Where the actions are ambiguous, the penalty needs to take that ambiguity into
account. The penalty should be larger the clearer is the breach, and where there is a
reasonable chance that the firm has simply ‘made a mistake’ the penalty should be
lower. This suggests that quite different penalties should be attached to different
behaviour. For example, an explicit price-fixing cartel is a clear breach and can
hardly be said to involve a ‘mistake’ by any participant. In contrast, it can be difficult
to separate predatory pricing from aggressive competitive activity and a firm that
engages in predatory behaviour “to run a competitor out of business” might
reasonably believe this to be the very nature of competition and not an illegal act. The
more ambiguous the violation, the lower should be the associated penalty.

2. While ambiguity is important, it is also important to recognize that firms can take
actions to prevent ‘mistakes’. Such actions are important for two reasons. First, to the
degree that firms can prevent mistakes, it is desirable that they do so. Second, if
showing that an action was simply an error can lower the penalty, firms will attempt
to hide deliberate breaches as ‘errors’. Firms need to be encouraged to put procedures
in place to prevent breaches – both deliberate and accidental – of competition laws.
One way to do this is to make penalties contingent on the internal procedures of the
firm. For example, firms need to establish internal training procedures to make junior

13
Ibid. at p.444. S. Salant, (1987) “Treble damage awards in private lawsuits for price fixing”,
Journal of Political Economy, 95, 1326-1336, notes that having private damages based on loss may lead to
manipulation of damages and this may partially explain the empirical findings by Block, Nold and Sidak.

8
 managers aware of their obligations under the Commerce Act. A firm that fails to
have such procedures should receive a harsher penalty and be less able to rely a claim
that the action was a ‘mistake’.

3. The individuals who directly breach the Act should be directly penalized. In theory
penalizing shareholders can substitute for direct punishment of managers who breach
the Act. As noted above, such managers will only aggressively pursue profits and
potentially break the law, if they are given high-powered, profit-based incentives. To
the extent that shareholders or the directors create these incentives, penalizing
shareholders can lead to lower-powered incentives and can prevent breaches of the
Act. Unfortunately, there are two reasons why penalty substitution between managers
and shareholders will not work perfectly. First, firms have a limited ability to punish a
manager for an illegal action. Second, managers receive rewards for higher profits
from the executive marketplace as well as their employer. A successful manager, who
boosts profits in his or her division, will appear successful and is likely to receive
lucrative job offers from other firms. Any attempt by a current employer to dampen
the manager’s enthusiasm and convince them to take the Commerce Act into account
may be swamped by the manager’s own career concerns.

It is difficult to impose significant monetary penalties on delegated employees. Ex

post firms may find it desirable to indemnify their employees to avoid general
discontent following successful prosecution under the Commerce Act. Even if it were
required that the employee pay any fine directly, compensation can be made by the
firm through a bonus that appears unconnected to the case. An alternative, that is far
more likely to directly affect the manager, is the threat of a prison sentence. Such a
sentence cannot be delegated and is costly to avoid. While prison sentences should
only be reserved for the most blatant breaches of the Commerce Act, the possibility
of such a penalty is likely to make managers much more concerned about their
obligations under the Act.

4. While the link between shareholders and managers can be weak, this does not mean
that shareholders or directors should be immune from penalties. In particular, some
breaches of the Commerce Act will have high-level involvement, and the relevant

9
 officers of the company should be directly liable for these actions. However, even if
lower-level management causes the breach, the firm’s CEO, directors and
shareholders should be liable to the degree that they have created the situation that
has led to the breach. In particular, if the firm uses high-powered profit based
incentives to reward managers, then the firm also needs to set up appropriate internal
controls to prevent these managers breaching the Commerce Act. If these controls are
lacking or are ineffective, then senior executives and shareholders should be liable.

These four proposals appear to differ significantly from the proposed changes to
the Commerce Act. The proposed changes appear to focus on firm-level penalties. But it
is far from clear that these will be effective or appropriate. In a complex delegated
system, such as a firm, high-level penalties imposed on shareholders who have little
direct control over firm operations seem to be inappropriate. At best, such penalties are
an indirect way of dealing with the problem. As a result, they might have little impact.
Further, to the degree that they do have an impact, this might be reflected in general low-
powered incentives for managers, preventing both socially desirable activities that
increase profits as well as illegal actions.

4. Appropriate remedies
In his chapter, Ian Millard presents a list of purposes for sentencing. An offender, found
guilty of breaching the law, is punished to gain social retribution and to denounce the
crime. But punishment is not merely social revenge. It also has a role in deterring future
offenses, protecting society and rehabilitating the offender. Existing penalties under the
Commerce Act satisfy the first two of criteria but do not deal with the final three
functions of sentencing. They do not address the underlying source of the problem that
led to the anti-competitive conduct. As a result, the penalties may have little effect in
either deterring future offenses, protecting society or rehabilitating the offender.

To see this, consider a firm that has abused its market power. This abuse might
have occurred through genuine error or because of poor control procedures for the
relevant managers. In such circumstances, the senior executives of the firm will not want
to see the breach repeated and will seek to rectify any internal management problems that
led to the breach of the Act.

10
 Raising fines for an accidental breach is unlikely to have much effect. The bad
publicity surrounding the case and the associated loss of reputation and customer
goodwill is likely to be a more significant impost on the firm than any fines. Where a
genuine mistake has occurred there is unlikely to be a repeat offence and penalties have
little role beyond spurring management to avoid future errors.

Alternatively, the abuse of market power might have been deliberate. Senior
management, having weighed up the costs and benefits of the abuse, taking the
probability of detection and successful prosecution into account, decided to engage in
anti-competitive conduct. The relevant managers may have acted simply to boost the
firm’s expected profit, allowing for the potential penalties if convicted. They might also
have considered the value to their own careers and incomes of a successful abuse of
market power. In such circumstances, increased fines will be factored into the managers’
deliberations, as would any other penalties such as potential prison terms. But, if the
abuse still occurs, then this means that the managers felt that the gamble of abusing
market power was worth taking.

Raising company-level fines will have some effect on such deliberations as they
raise the costs associated with any abuse of market power. But such fines seem to be an
indirect way, and probably an ineffective way of deterring, protecting or rehabilitating.
After successful prosecution, the rewards and benefits to the company from a future
abuse of market power remain unchanged. The company has simply tried once to gamble
with the Commerce Act and lost. This loss need not prevent similar gambles in the future.
The penalties under the Commerce Act do not affect any of the underlying structural
features of the industry that made the abuse possible. The firm could only abuse its
market power because it had market power, and the penalties under the Act do not
address the firm’s market power.

If the role of penalties is to deter and protect then this can only be achieved by
reducing or eliminating the underlying structural problems that made possible a breach of
the Act. This suggests that appropriate remedies need to involve ongoing changes to the
industry. At one end, these changes might simply involve industry oversight. At the other

11
extreme, structural adjustment, such as breaking-up the offending company, might be
appropriate.

Breaking-up an offending company to remove or dilute its market power has been
used in the United States. For example, the break-up of Standard Oil in 1911,14 involved
both horizontal and vertical restructuring of the oil industry in the United States.
Similarly, the Justice Department’s case against AT&T led to the modified final
judgment in 1984, that separated the company’s long distance and local telephone
operations and created the regional ‘Baby Bell’ telephone companies. More recently, the
U.S. government recommended a break-up as the appropriate remedy to abuse of market
power allegations against Microsoft Corporation.

Restructuring a company is a controversial remedy.15 It should only be used

where the case against the offending firm is clear and the break-up makes economic
sense. It does go, however, to the heart of an abuse of market power, and is far more
likely to be successful in protecting society from further anti-competitive actions than
imposing fines. By eliminating the market power that is the source of the abuse and
artificially forcing competition on to the market place, restructuring provides a powerful
pro-competitive remedy.

Less severe remedies can also be used to help prevent future offenses. For
example, it might be required that a company sell-off one of its divisions, that it cannot
participate in certain corporate activities such as tenders for a specified period of time, or
that it be required to provide access to certain facilities to potential competitors. Where
the anti-competitive practice involved a contract, the court could require that the contract
be appropriately modified or that the contract is void. If the practice involved a collusive

14
United States v Standard Oil Company of New Jersey, et. al., 221, U.S. 1 (1911)
15
For example, a number of commentators have claimed that the proposed structural separation of
Microsoft will reduce competition and raise consumer prices. See S. Liebowitz (2000), “An expensive pig
in a poke: estimating the cost of the District Court’s proposed breakup of Microsoft”, mimeo, University of
Texas at Dallas, and R. Hahn (2000), “U.S. v Microsoft: breaking up should be hard to do”, working paper,
AEI-Brookings Joint Center for Regulatory Studies, Washington.

12
agreement then on-going monitoring of the industry might be appropriate, with firms, for
example, being required to independently and confidentially submit their price lists to a
regulatory authority.

It could be argued that all these types of industry specific remedies represent
undesirable interventions in the market place. Breaking-up a firm might lead to a loss of
economies of scale or scope. Voiding existing contracts might create concerns about
regulatory risk in future contract negotiations. Requiring companies to submit their prices
to regulatory scrutiny creates ongoing compliance costs. These arguments are all correct,
but they miss the key point. The remedies are only imposed on firms or industries that
have already proven to be dysfunctional. In other words, the remedies are not impositions
on a well-functioning competitive market. Rather, they only come into play after the
courts have found a significant failure of competition in the industry, and they represent a
‘second best’ method of improving the behaviour of the industry. The remedies are not
inefficient imposts on an industry but a means to overcome existing industry problems.

5. Conclusion
Overall, there is little evidence that the proposed changes to penalties under the
Commerce Act are likely to significantly affect the level of anti-competitive behaviour in
New Zealand. Like Ian Millard, I believe that better funding for enforcement might be a
preferable route compared to increased fines. More significantly, however, I believe that
the changes represent a lost chance for New Zealand. Instead of ‘more of the same’, the
reforms could have followed a difficult, controversial, but significantly more rewarding
path. A better approach would be to have penalties that directly face the delegated agent
problems associated with competition law and remedies that focus on the underlying
industry characteristics that allow anti-competitive conduct to occur. Because the
proposed reforms have not faced the real issues underlying penalties and remedies for
anti-competitive conduct, they are unlikely to lead to significant gains. The losers will be
the New Zealand public.

13