Peer Learning, Strategic Experimentation, and Regulator Reputation

We consider a dynamic model featuring two firms that test a regulator’s enforcement propensity through their misconduct and a regulator that disciplines them to build a reputation for strict enforcement. We show that when the regulator has full discretion over the enforcement criterion, peer learning about each other’s enforcement outcome creates not only information externalities but also endogenous enforcement externalities, which increase misconduct when the regulator is sufficiently patient and reduce it otherwise. Without regulatory discretion, however, the enforcement externalities vanish and peer learning lowers misconduct. Our results have implications for enforcement transparency, regulatory decision horizons, and regulatory discretion