Compromising Accuracy to Encourage Regulatory Participation

This paper examines the value of accuracy in voluntary or opt-in regulatory regimes. We show that if welfare depends primarily on the ability to identify noncompliant firms, tolerating mistakes in concluding that firms meet regulatory standards (false positives) can improve welfare. Consumers or investors anticipate the regulatory error rate and discount the positive message of a compliance finding. Welfare is nonetheless improved because the mistaken exoneration acts as an incentive for noncompliant firms to submit to regulatory scrutiny, and as a result some noncompliant firms are unmasked.