Jean Monnet Center at NYU School of Law


2. Regulatory competition: theoretical underpinnings

The term "regulatory competition" refers to a process whereby legal rules are selected (and de-selected) through competition between decentralised, rule-making entities (which could be nation states or other units such as regions or localities). Three justifications are normally given for regulatory competition: firstly, it allows the content of rules to be matched more effectively to the preferences or wants of the consumers of laws (citizens and others affected); secondly, it promotes diversity and experimentation in the search for effective legal solutions; and thirdly, by providing mechanisms for preferences to be expressed and alternative solutions compared, it promotes the flow of information on effective law making.

In Tiebout's influential formalisation of this idea,3 the mechanism through which competition operates is mobility of persons and resources across jurisdictional boundaries. In his "pure theory" of fiscal federalism, local authorities compete to attract residents by offering packages of services in return for levying taxes at differential rates. Consumers with homogenous wants then "cluster" in particular localities. The effect is to match local preferences to particular levels of service provision, thereby maximising the satisfaction of wants while maintaining diversity and promoting information flows between jurisdictions.

Tiebout's model can be applied to laws since they, like public services, have the character of what economists refer to as indivisible public goods, that is to say, they cannot easily be priced individually because of issues of non-excludability. Hence collective consumption is more cost-efficient. Laws, then, are seen as products which jurisdictions supply through their law-making activities, in response to the demands of consumers of the laws, that is, individuals, companies and other affected parties. If supply and demand can be brought into equilibrium, then, in the terminology of welfare economics, static or allocative efficiency will be maximised. This is another way of saying that the wants or preferences of the various parties will have been satisfied to the greatest possible extent.

At the heart of this conception of regulatory competition is decentralisation. The process cannot work unless effective rule-making authority is exercised by entities operating at a devolved or local level. It is argued that a centralised or "monopoly" regulator would, by contrast, behave like any other monopoly; contrary to the normal laws of supply and demand, the price of the product goes up while the quantity supplied diminishes, so driving a wedge (a "social cost") between an optimal economic outcome and what actually occurs. To avoid this outcome implies conferring law-making powers on lower-level units, subject only to the principle that there must be some level below which further decentralisation becomes infeasible because of diseconomies of scale.

Perhaps the best known case of regulatory competition is the so-called Delaware effect in US corporations law. Over 40% of New York stock-exchange-listed companies, and over 50% of Fortune 500 companies, are incorporated in Delaware. Some commentators have argued that Delaware's success in attracting such a high level of company incorporations has been achieved by lowering standards.4 As Cary has famously argued,5 when coining the term "race to the bottom" about Delaware, the state has gained its pre-eminence in the corporate charter market due to its ability to attract incorporations favourable to managers at the expense of shareholders. He claimed that corporate standards were deteriorating, particularly in respect of fiduciary duties, leading to the rights of shareholders vis-à-vis management being watered down to "a thin gruel".6 As part of this process, Delaware, "a pygmy among the 50 states prescribes, interprets, and indeed denigrates national corporate policy as an incentive to encourage incorporation within its borders, thereby increasing its revenue".7 To counter this, Cary proposed the enactment of a Federal Corporate Uniformity Act, allowing companies to incorporate in the jurisdiction of their own choosing but removing much of the incentive to organise in Delaware or its rival states.8

Although some EC company lawyers have supported harmonisation precisely in order to avoid a Delaware style "race to the bottom",9 the idea that Delaware law represents a lowest common denominator has been challenged by accounts which argue that any attempt by managers to downgrade shareholder interests would, over time, lead to a hostile response by the capital markets. Managers therefore have an incentive to incorporate under the law of a state which favour shareholder interests since "[s]tates that enact laws that are harmful to investors will cause entrepreneurs to incorporate elsewhere".10 If this is the case, "Delaware attracts incorporations not because its laws are lax, but because they are efficient".11 Thus, some commentators argue that Delaware has so perfected the art of matching its laws to the demands of the users of those laws that it has won the race to the top.12 In general, while the claim that Delaware company law is efficient remains much disputed,13 it is generally agreed that regulatory competition need not, necessarily, imply a degradation of standards.14

In terms of the legal framework required, the pure theory envisaged by Tiebout is clearly opposed to harmonising measures which aim to impose uniform laws on local jurisdictional entities. These laws would simply obstruct the spontaneous movement to equilibrium of the forces of supply and demand. However, it is less often noticed that the pure theory is ambivalent with regard to centralised judicial review of national-level regulation. This is because, in a perfectly competitive market for legal rules, it would be enough for the courts formally to guarantee the right of free movement on the part of the consumers of laws. In the somewhat unrealistic world imagined by the pure theory, the correct response to a legislature which, for example, banned the advertising of alcohol (as in GIP15), or which insisted on applying its own minimum wage legislation to foreign workers on its territory (as in Rush Portuguesa16), would be for the factors of production to decide whether or not to quit that state for one which provided a more appropriate regulatory regime. Hence voters who were unhappy with a state's alcohol advertising ban would exit to what they regarded as a more congenial legal regime, while labour-only subcontractors would shun a country which applied its labour standards in an over-rigid way.

Taking the process back one stage, such laws could be avoided in the first place in so far as their negative effects imposed a potential cost on legislators in the jurisdictions adopting them. If such laws reduced the wealth of the citizens of the country concerned, legislators would, it is presumed, have an incentive to avoid adopting them (this would be the case if the well-being of the legislators was linked to the well-being of the country in some way). On the other hand, it might well be the case that citizens (and legislators acting on their behalf) prefer to pay the price for having high standards in areas of product safety and social policy. They may prefer, in other words, to trade off a part of national wealth in return for social redistribution or environmental protection. If this is the case, there is nothing in the pure theory to say that they should not have the right to do so. A federal judicial body should no more prevent the exercise of local-level sovereignty by striking down such laws, than a federal legislature should seek to occupy the field at their expense.

As we have seen, in the world of the pure theory, freedom of movement is assumed for the purpose of setting up the formal economic model. The model does not aim to explain the institutional underpinnings of mobility (such as the mechanics of the principle of non-discrimination, and the (federal) legislation to facilitate free movement). Instead, the model is aimed at showing that, given an effective threat of exit, spontaneous forces would operate in such a way as to discipline states against enacting laws which set an inappropriately high (or low) level of regulation. The model can, however, be used as a benchmark against which to judge institutional measures aimed at instituting regulatory competition. Since, in the "real" world, mobility of persons and of non-human economic resources is self-evidently more limited than it is in the world of pure theory, two prerequisites for making exit effective may be identified: legal guarantees of freedom of movement for persons and resources, and application of the principle of mutual recognition.17 In addition, it is accepted that some unwanted side effects of competition ("externalities" or spill-over effects of various kinds) may arise, thereby giving rise to an efficiency-related argument for some harmonisation, although there is in general a presumption against federal intervention and in favour of allowing rules to emerge through the competitive process. Thus the task of analysis, in this approach, becomes that of identifying how far the "real world" departs from the pure theory, and using legal mechanisms to realign the two.18 This is the approach to regulatory competition which is generally characterised as competitive federalism.

3 C Tiebout, "A pure theory of local expenditure" (1956) 64/5 Journal of Political Economy 416.

4 For further details, see C Barnard "Social Dumping Revisited: Lessons from Delaware" (2000) 25 ELRev 57 and C Barnard, "Regulating Competitive Federalism, in the European Union? The Case of EU Social Policy" in J Shaw (ed), Social Law and Policy in an Evolving European Union, (Oxford, Hart, 2000).

5 W Cary, "Federalism and Corporate Law: Reflections Upon Delaware" (1974) 83 Yale Law Journal 663, 669.

6 Ibid 666.

7 Cary, supra, n.5, 701.

8 Ibid , 701.

9 C Schmitthoff, "The future of the European company law scene", in C. Schmitthoff (ed.) The Harmonisation of European Company Law (London: UKNCCL, 1973), 9..

10 Amanda Acquisition Corp. v. Universal Foods Corp. 877 F.2d 496 (1989), per Easterbrook J., cited in D Charny, "Competition among jurisdictions in corporate law rules: an American perspective on the `race to the bottom' in the European Communities", in S Wheeler (ed.) A Reader on the Law of the Business Enterprise (Oxford, OUP, 1994). See also F Easterbrook and D Fischel, "The corporate contract" (1989) 89 Columbia Law Review 1416.

11 Charny, supra n.5, 371.

12 See, for example, R Winter, "State Law, Shareholder Protection and the Theory of Corporation" (1977) 6 J.Leg.Stud. 251; D Fischel, "The `race to the bottom' revisited: Reflections on recent developments in Delaware's Corporation Law" (1982) Northwestern University Law Review 913, 916 and 920. See also F Easterbrook "The Economics of Federalism"(1983) 26 Journal of Law and Economics 23, 28 and F Easterbrook and D Fischel, "Voting in Corporate Law" (1983) 26 J.L.&Ec.395.

13 L Bebchuck and A Ferrell, "Federalism and takeover law: the race to protect managers from takeovers" (1999) 99 Columbia Law Review 1168.

14 See generally the essays in D Esty and D Geradin (eds.) Regulatory Competition and Economic Integration: Comparative Perspectives (Oxford, OUP, 2001).

15 Case C-405/98 Konsumentombudsmannen (KO) v Gourmet International Products AB (GIP), judgment of 8 March 2001.

16 Case C-113/89 Rush Portuguesa Ltda v. Office Nationale d'Immigration [1990] ECR I-1417.

17 Mutual recognition is considered further in Kenneth Armstrong's chapter.

18 R Van den Bergh, "The Subsidiarity Principle in European Community Law: Some Insights from Law and Economics" (1994) 1 Maastricht Journal of European and Comparative Law 337.




This site is part of the Academy of European Law online, a joint partnership of the Jean Monnet Center at NYU School of Law and the Academy of European Law at the European University Institute.
Questions or comments about this site?