Industry Self-Regulation: A Game-Theoretic

Typology of Strategic Voluntary Compliance

Simon ASHBY∗, Swee Hoon CHUAH† and Robert HOFFMANN†

April 7, 2003

Abstract

We analyse the possibility of successful industry self-regulation interms of the strategic interactions between industry members and gov-ernment. In particular, this paper presents a game-theoretic typologyof generic self-regulatory scenarios and evaluates these in terms of theresulting likelihood of collective compliance. Examples for the sce-narios are discussed and conclusions for corporate and public policyoffered.

JEL-Classification: C72, D7, H11, K20, L51Keywords: industry self-regulation, voluntary compliance, game theory,

public goods, collective action.

1 Introduction

Industry self-regulation is one of many alternative forms of regulative (asopposed to incentive-based) government initiative to correct market failure.Essentially, it involves government initiating and delegating the managementof a regulatory process to the industry itself. For both political and economicreasons, arrangements of this type are becoming more widespread especiallyin countries with liberal traditions, such as the UK and US (Baggot, 1989;Leveque, 1996; Scarpa, 1999). The emergence of self-regulation has raised anumber of important research issues which are being tackled by a growing

∗The Financial Services Authority, 25 The North Colonnade, Canary Wharf, LondonE14 5HS, United Kingdom

†Nottingham University Business School, Jubilee Campus, Nottingham NG8 1BB,United Kingdom. E-mail of corresponding author: robert.hoffmann@nottingham.ac.uk.WWW: http://www.nottingham.ac.uk/business/

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but dispersed literature that has emerged across a number of disciplines,such as public administration (Baggot, 1989; Wotruba, 1997), law (Van Cise,1966; Rosenberg, 1976; Blumrosen, 1983; Cane, 1987; Page, 1986; Ogus,1994), economics (Telser, 1980; Shaked and Sutton, 1981; Pirrong, 1998;Nunez, 2001), business (Garvin, 1983; Gupta and Lad, 1983; Maitland, 1985;Ruhnka and Boerstler, 1998) and environmental management (Bomsel et al.,1996; Leveque, 1996; Bennet, 1999; King and Lenox, 2000). These issuesinclude the advantages of self-regulation over statutory regimes, the natureand design of specific self-regulatory processes and the welfare effects ofself-regulation in terms of industry performance and public accountability.

Despite their diverse origins, most studies share a concern with the costsand benefits of self-regulation compared with statutory regimes. A compre-hensive list of such costs and benefits has been identified which are discussedin detail elsewhere (Ogus, 1994; Page, 1986; Gupta and Lad, 1983; Doyle,1997; Wotruba, 1997). In summary, a functioning self-regulatory arrange-ment is known to have potential administrative economies and design ad-vantages over statutory regimes while credibility, accountability and captureproblems also exist. In contrast, relatively few studies have explicitly investi-gated the conditions for individual firm compliance successful self-regulationnecessarily rests on. This issue is, however, clearly important (Gupta andLad, 1983; Page, 1986). Any comparative advantages of self-regulation canonly be realized when a sufficient number of firms in the industry decide tocomply with the regime.

In response, a number of authors have investigated firm compliance in-centives. Voluntary adherence to environmental or ethical standards canhelp to raise a firm’s image with key stakeholders (McWilliams and Siegel,2000). In addition, operating cost or efficiency savings may also becomeavailable (Hart, 1995; Russo and Fouts, 1997; Klassen and Whybark, 1999;Dechant and Altman, 1994). These types of benefits are essentially privatein nature, i.e. accrue only to the compliant firm. Their effects on firmprofits have been discussed extensively in the literature on corporate socialresponsibility (McWilliams and Siegel, 2000). Clearly, when individual firmcompliance generates sufficient private net benefits, no issue of regulationexists. This is unlikely to be the case generally. However, compliant be-havior may generate additional, external benefits which are in nature publicto the industry as a whole, i.e. accrue equally to compliant as well as non-compliant firms. For instance, responsible firm behavior may enhance thereputation of an industry as a whole when stakeholders imperfectly differ-entiate between industry members (Garvie, 1999; Bomsel et al., 1996). Inaddition, there is plentiful evidence that firms use self-regulation as a vehi-

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cle to avert more direct government regulation (Bomsel et al., 1996; Page,1986; Baggot, 1989; Gunningham and Rees, 1997; Sinclair, 1997). Statutoryintervention is often regarded as disruptive and costly to individual firms,while industry influence on rule-making can generate laxer, and technicallymore appropriate guidelines (Anonymous, 2000; Baggot, 1989).

This observation points to a a free-riding issue in industry collectiveaction to sustain self-regulation (Maitland, 1985; Garvie, 1999; Gunninghamand Rees, 1997; Bomsel et al., 1996; Leveque, 1996; Sinclair, 1997; Shiell andChapman, 2000). The essential problem is that each firm may benefit fromthe compliance of others irrespective of its own behaviour. In short, whilemutual compliance may afford collective gains to the industry, individualfirm incentives to free ride on the cooperation of others may also exist. Theresulting intra-industry collective action problem is therefore a key obstacleto successful self-regulation.

The ability of an industry to overcome the free-riding problem is contin-gent on firms’ individual compliance motives as well as their strategic inter-actions. This issue can be conveniently studied using game theory. In theliterature, particular experiences with self-regulation have been cast in termsof games, in particular the Prisoner’s Dilemma (Maitland, 1985; Shiell andChapman, 2000) and the Assurance Game (Maitland, 1985). This approachis fruitful as it allows us to discuss the feasibility of a particular instance ofself-regulation in terms of the underlying dynamics of the game concerned.Self-regulation is possible or impossible depending on which game applies toa particular case.

The limitation of these contributions is that they focus on particular self-regulatory cases. As a result, little is known about which games may describedifferent self-regulatory cases generally, and what circumstances cause a par-ticular game to apply in a specific case. A more general framework wouldpermit a comprehensive strategic analysis of self-regulation which can beapplied to particular cases. Our aim in the current study is to constructsuch a tool. Our approach is to provide a general game-theoretic analysisof the possibility of self-regulation in terms of firms’ compliance decisionswhen a public-good dimension exists. We derive a typology of alternativeself-regulatory games on the basis of alternative assumptions concerning in-dustry as well as government motives. The typology classifies self-regulatoryscenarios in terms of the nature of their associated public-good problems.These are subsequently analyzed in terms of the possibility of self-regulation.The aim of this exercise is to uncover and classify the strategic conditionsnecessary to generate acceptable firm compliance levels. The typology is use-ful both to explain the past success or failure of particular self-regulatory

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arrangements and to to ascertain the suitability of self-regulation for indus-tries where no experience with this type of regime exists. Section 2 developsthe typology and provides the strategic analysis of the games concerned togenerate conclusions about the possibility of self-regulation. Section 3 ap-plies the typology to three recent experiences with self-regulation in the UK.Section 4 concludes the paper.

2 A Typology of Self-Regulation

Industry self-regulation is a government-initiated process where a code ofcorporate conduct is formulated and enforced at the industry level (Guptaand Lad (1983), p.417, Baggot (1989), p.436, Page (1986), p.144-145, Ogus(1994), p.376). Arrangements of this type are typically governed by explicit,rather than informal mechanisms financed and maintained by the industrythrough a self-regulatory agency (SRA). They are based on essentially vol-untary firm compliance due to the SRA’s lack of legal powers of sanction.Moreover, they are accompanied by an explicit threat of statutory interven-tion in the case of self-regulatory failure. In this section, we use standardgame theory to identify and analyse possible self-regulatory scenarios. Thesealternative possibilities arise depending on the motives firms and governmentface in a particular case.

For simplicity, we envisage an industry of two identical firms which si-multaneously choose between complying with (c) and violating (v) a self-regulatory regime.1 Subsequently, government decides between persistingwith self-regulation (del) and legislating (leg) for the introduction of statu-tory intervention. The result is the decision-making process with eight pos-sible outcomes and associated payoffs for these three players shown in thegame tree in figure 1.

Table 1 describes the game’s payoffs. The two firms incur costs bothin terms of maintenance of the SRA and abatement. Total agency costs Care incurred from creating and maintaining the SRA and are shared by allcompliant firms. These costs reflect expenditures involved in establishinga suitable institution, devising rules and monitoring member compliance.Abatement cost is the cost of refraining from the activity subject to gov-ernment scrutiny. These are generally held to be greater under stricterstatutory intervention (K ) than under self-regulation (k). The (positive)

1Gupta and Lad (1983) as well as Leveque (1996) make a number of observationsconcerning the issue of firm asymmetry. Clearly, this issue is of interest and might providea possible extension to the current model.

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Firm 1

Firm 2 Firm 2

G GGG

complycomply

comply

violate violate

violate

- /2- /2

-

CC

A R

B CB CA r

- /2- /2-

-0

-

C

A R

B CBa r

-

-

0-

-C

A R

BB Ca r

--

00

-A R

BBr-

leg deldeldeldelleg legleg

Figure 1: The process of self-regulation in extensive form. The two firmstake simultaneous compliance decisions followed by government’s (G) choicebetween legislating for statutory intervention (leg) and continuing with thedelegation of the regulatory process to industry (del). The payoffs associatedwith each outcome are for firm 1, firm 2 and government in that order. Thedashed information set indicates simultaneous firm decisions.

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A government benefit from complete industry abatementa government benefit from partial industry abatementR government cost of statutory regulationr government cost of self-regulationK firm abatement cost under statutory regulationk firm abatement cost under self-regulationB firm relative benefit from self-regulation (K − k)C industry administrative cost of self-regulation

Table 1: Model variables and their descriptions.

net benefit of self-regulation over a statutory regime from the firm’s per-spective is therefore K − k, which we denote as B. In the game tree, wehave added K to all firm payoffs in order to cast the situation in terms ofthe comparative benefits of self-regulation over a statutory regime. In thisnotation, statutory regulation constitutes the status quo for the firms, as-sociated with a payoff of zero. This transformation makes no difference tothe game’s analysis as it leaves the relative sizes of firm payoffs unaffected.

Government payoffs consist of costs and benefits arising from industryabatement and regulatory administration. In particular A and a reflect thedifferent levels of industry abatement benefits obtained under total and par-tial industry compliance respectively (where A > a). Similarly, R and rdenote the government’s regulatory costs of statutory regulation and self-regulation respectively such that R > r. The parameter R therefore consti-tutes the cost to the public purse from devising suitable legislation as well assetting up and maintaining a statutory regulator. Conversely the lesser costsof initiating self-regulation and monitoring the arrangement’s performanceare reflected in r.

In order to analyse the game tree in figure 1, we need to know moreabout the relative size of the payoffs just discussed. In particular, it isconvenient to rank the eight outcomes for each of the players in terms ofpreference. Clearly, different such rankings are possible depending on theparticular industry under consideration. A number of different constellationsleading to alternative strategic scenarios are possible in this context. In thefollowing, we identify and analyze these by exploring alternative assumptionsconcerning the relative size of the parameters.

We start by analysing government motives. From figure 1, governmentreceives either (A−R), (A− r), (a− r) or (−r), depending on the outcome.As a result, full industry compliance and delegation of regulation is the

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Figure 2: The zero tolerance regime as a 2×2 game.

most preferred outcome. Conversely, complete industry violation under self-regulation is the worst outcome. The ranking of the remaining six outcomesdepends on the relative sizes of A−R and a−r respectively. If A−R > a−r,then the government’s net benefit from self-regulation with partial industrycompliance is less than the net benefit of statutory regulation. As a result,only total industry compliance is acceptable for self-regulation to be allowedto persist. Conversely A − R < a − r indicates that self-regulation withpartial industry compliance is sufficient to outweigh the net benefit of astatutory regime. This relationship between A − R and a − r can thereforebe interpreted as a measurement of governmental tolerance towards non-compliance under self-regulation. We term the two resultant possibilitiesthe zero tolerance and partial tolerance regimes respectively. In the firstcase the self-regulatory regime is replaced by more direct intervention whenat least one firm deviates, and in the second, only when both firms deviate.In the following we consider both regimes.

2.1 Zero Tolerance Regime

Government payoffs may be such that self-regulation is deemed viable onlywhen total individual firm compliance is achieved (A−R > a− r). In figure1, government will then opt for del only if both firms comply, otherwise legwill be chosen. As government choice is known under this assumption, wecan eliminate it from the analysis by pruning the game tree of its dominatedactions. Only four possible outcomes remain. The choices facing the twofirms can therefore be represented in simplified form as a 2×2 game (figure2).

As before, different specific games are possible depending on the rela-tive size of the symbolic payoffs, in this case B and C. We can distinguishalternative strategic scenarios on their basis. First, positive values for Band C mean that unilateral firm compliance is always the worst of the four

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1, 1 -1, 0

0, -1 0, 0

-1, -1 -2, 0

0, -2 0, 0

(b)

Figure 3: The two zero tolerance scenarios in symmetric 2×2 normal form.They are (a) the Assurance Game and (b) a game in which compliance isstrictly dominated. Arbitrary integers obeying the games’ respective condi-tions are used for illustration.

outcomes as costs are incurred but no benefits arise due to the failure ofself-regulation. Secondly, firms are indifferent between unilateral or mul-tilateral violation. As a result, zero tolerance can result in two specificgames, depending on whether firms prefer mutual compliance to violation(i.e. whether B − C/2 > 0). The two resulting scenarios are illustrated bythe matrices in figure 3.

The first self-regulatory scenario within a zero tolerance regime ariseswhen B − C/2 > 0. A set of hypothetical payoffs obeying this condition isshown in figure 3(a). This first game is commonly known as the AssuranceGame. An individual firm’s benefit from self-regulation exceeds its share ofthe cost (B > C/2). As mutual compliance is the best outcome for bothfirms, their interests coincide. However, mutual compliance is only one oftwo pure Nash equilibria in the game.2 If the other firm is anticipated tocomply, compliance is both firms’ best reply to secure the benefits of self-regulation. Conversely, if opponent violation is expected, violation is thebest alternative as self-regulation cannot be safeguarded unilaterally. As aresult, two Nash equilibria exist in mutual compliance and mutual violationrespectively.

The second scenario under a zero tolerance regime arises when B−C/2 <0 (figure 3(b)). For the individual firm, the benefit from compliance isoutweighed by the individual cost even when the total cost is shared amongall firms (B < C/2). The nature of the industry in question is such that thecost of setting up and maintaining a suitable self-regulatory arrangementexceeds any benefits. Violation is therefore the dominant strategy for allplayers. Clearly, there is no scope for self-regulation in this situation as the

2A Nash equilibrium is an outcome where each player’s move is a best reply to all otherplayers’ moves. This mutual adaptation implies stability as no player has any incentiveto deviate from their current play. In the following, we will restrict our attention to pureNash equilibria, where players make particular moves with probability 1.

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Figure 4: The partial tolerance regime as a 2×2 game.

unique equilibrium in pure strategies for all versions of this game is mutualviolation.

2.2 Partial Tolerance Regime

The partial tolerance regime entails government costs and benefits such thatA − R < a − r. Government will only legislate when both firms violate theself-regulatory arrangement. One firm’s compliance is therefore sufficient tosustain self-regulation. Firm choice under the regime is depicted in figure 4.

Again, we need to specify the players’ rankings of the four outcomes toproceed with our analysis. In general, there are 4! = 24 strict orderings offour unequal values and therefore as many games can exist in this regime.However, as before, we can narrow this number down by investigating therelationship between the individual payoffs in the game’s matrix (figure 4).To begin with, the matrix reveals that under positive self-regulatory admin-istration cost C and positive net regulatory benefits B, unilateral violationis the most preferred outcome for each of the firms. Secondly, mutual com-pliance is preferred to unilateral compliance. Of the twenty-four possibleorderings, eighteen are eliminated from our typology as unilateral violationis required to be the most preferred.3 Out of the remaining six, only threeobey our second requirement. As a result, there are three self-regulatoryscenarios under partial tolerance.

The first partial-tolerance scenario arises when both unilateral and mu-tual compliance are preferred to mutual violation. In this game, the break-down of self-regulation when the entire industry fails to adhere is the worstoutcome. The benefit of establishing successful self-regulation for each firmoutweighs the total, unilateral cost of its provision (B > C). In other words,one firm’s relative benefit from self-regulation exceeds the total administra-

3The process of elimination can be easily verified by listing the 24 orderings and deletingthose which violate the two requirements stated.

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2, 2 1, 3

3, 1 0, 0

1, 1 -1, 2

2, -1 0, 0

(b)

-1, -1 -2, 1

1, -2 0, 0

(C)

Figure 5: The three partial tolerance scenarios in symmetric 2×2 normalform. They are (a) the Chicken Game, (b) the Prisoner’s Dilemma and (c)another game in which compliance is strictly dominated.

tion cost to the industry. For illustrative purposes an example of payoffsobeying these conditions is presented in figure 5(a). The game is commonlyknown as the Chicken Game.

The Chicken Game has two pure-strategy Nash equilibria in unilateralcompliance. Each firm’s best reply is to adopt the opposite strategy tothat of the other. As the benefit of unilateral compliance outweighs itscost, firms will comply if others are expected to violate in order to sustainthe regime. Conversely, individual violation would be the best responseif an opponent was known to choose compliance. In this situation, theviolating firm may secure the benefits of self-regulation without incurringthe associated compliance costs. As a result, this scenario has potentialfor the development of reputations by the firms. In particular, a ‘reckless’reputation for unconditional violation may persuade a firm’s competitorsto comply in this scenario. Free-riding on the restraint of others is thenpossible.

The second partial-tolerance scenario is defined by the additional condi-tion C/2 < B < C. The interpretation of this inequality is that the costs ofunilateral compliance outweigh the benefits that self-regulation can generatefor an individual firm. However, the benefit obtainable from complying withthe self-regulatory regime when others comply exceeds an individual’s shareof the cost. As a result, successful self-regulation in this scenario can only besustained through cooperation between firms. An example of this situationis illustrated in figure 5(b). The combination of a firm’s individual incen-tive to violate and the mutual optimality of compliance yields the Prisoners’

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Dilemma Game. Each firm’s best response to opponent violation is to alsoviolate as the cost of individual maintenance of the SRA exceeds the relativebenefit of self-regulation. Violation is also the best reply when the other firmcomplies as this affords an opportunity to free-ride on others’ maintenanceof self-regulation. The unique Nash equilibrium of the one-shot Prisoner’sDilemma is mutual violation of the self-regulatory agreement. However, co-operation between firms can emerge in versions of the game with repeatedplay, limited player information and rationality. In essence, the ability offirms to develop reputations for reciprocal behaviour (such as Tit-for-Tat)may induce cooperation from competitors. As a result, both violation andcompliance may result from industries in this scenario depending on theconditions of play.

The third partial-compliance scenario has the additional condition B <C/2 (figure 4). This game is illustrated in figure 5(c). The game is remi-niscent of game 2. Again, self-regulation is unsuitable for industries of thistype as individual firm motives as well as the collective industry interestpreclude voluntary compliance.

3 Three Cases of Self-Regulation

Self-regulatory experiences can be classified in terms of the nature of gov-ernment motives as well as the public good problem they present to theindustries concerned. The previous section has outlined a game-theoretic ty-pology that can be used to assess the possibility of successful self-regulationon the basis of the underlying games. This framework can be used in theanalysis of actual or proposed cases of self-regulation. This process consistsof two steps: the identification of the underlying game, and its analysis aswell as application to the industry at hand.

Figure 6 presents our typology schematically. A paticular instance ofself-regulation is identified firstly in terms of government tolerance, andsubsequently on the basis of firm costs and benefits of self-regulation. Table2 is a tool for this purpose. It provides an indication of the relationshipbetween relative variable sizes and the resulting applicable games. In thefollowing, we outline three recent experiences with self regulation in theUK in terms of this typology. Our analysis of these cases is intended todemonstrate the application of the framework proposed here and thereforeremains somewhat indicative. Fully-blown case studies are currently thesubject of further research.

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Self-Regulation

Zero Tolerance Partial Tolerance

Game 1:Assurance

Game 2 Game 3:Chicken

Game 4:Prisoner’sDilemma

Game 5

Figure 6: A typology of self-regulatory scenarios on the basis of players’strategic motives.

Game A a R r B C

Assurance Game H L L H H LGame 2 H L L H L HChicken Game L H H L H LPrisoner’s Dilemma L H H L M HGame 5 L H H L L H

Table 2: Classification of self-regulation. Actual or proposed self-regulatoryregimes can be identified in terms of the five scenarios to the extent that therelative sizes of decision variables tend to be H = high, M= medium and L= low.

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3.1 UK Advertising as an Assurance Game

The Assurance Game has been applied to cases of self-regulation by otherauthors (see e.g. Maitland (1985); Shiell and Chapman (2000)). Our ty-pology identifies these cases generally as industries with relatively high A, rand B as well as relatively low a, R and C (see table 2). Another likely ex-ample is UK Advertising. The Advertising Standards Authority (ASA) wasset up in 1962 as a self-regulatory agency to ensure non-broadcast adver-tising remain ‘legal, decent, honest and truthful’, ‘prepared with a sense ofresponsibility to consumers and society’, and finally ‘in line with the prin-ciples of fair competition’ (Advertising Standards Authority, 2003). Theapplicability of the Assurance Game to this instance of self-regulation restsfirstly on the UK government’s pursuit of a zero tolerance regime. A 2000White Paper demonstrated the UK government’s resolve to introduce statu-tory regulation in the advertising sector if necessary, indicating that a de-cline in compliance with the ASA code may prompt its dissolution (Cozens,2000). We may speculate as to the reasons for this apparent stance. First,the regulatory cost saving associated with self-regulation in this industryis small (R low compared with r). Van Cise (1966) argues that difficultiesin a statutory regulation process arise from both time-lags between vio-lation and censure as well as technical complexities, both generating highregulatory cost. Neither is the case in advertising; due to its nature, bothmonitoring and adjudication are relatively simple, enabling government togenerate prompt responses. On the other hand, the highly public nature ofany code breaches makes high compliance levels politically desirable (A highcompared with a). Finally, advertising self-regulation provides the industrywith high benefits at relatively low costs (B high compared with C ). Again,the low cost is due to the nature of advertising which makes monitoring andadjudication simple.

The chances of successful self-regulation in the Assurance Game aregood. Mutual compliance is the most preferred outcome for all players, en-dangered only by the possibility of mis-coordination between them. Mait-land (1985) describes how a SRA can perform a coordinating function toassure industry members of mutual compliance. This is also the experiencein the UK Advertising industry. Compliance with the ASA’s code of conductis generally good. According to the ASA’s own figures, 97% of press adver-tisements, 98% of posters and 85% of direct marketing material complieswith its code of conduct (Advertising Standards Authority, 2003). Ireland(1995) quotes a survey of national newspapers in 1991 which found thatbetween 0.2% and 9.6% of over 35,000 adverts potentially failed to comply

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with the ASA’s code and concludes favourably for the self-regulatory regime.Similarly, the UK Government recently rejected calls for the statutory reg-ulation of advertising on the basis of the ASA’s performance (Cozens, 2000;Garrett, 2000).

3.2 UK Press as a Chicken Game

To our knowledge, the Chicken Game has not previously been used in theanalysis of self-regulation. From table 2, the game applies to industries whichare characterised by relatively high a, R and B as well as relatively low A,r and C. An example is provided by the UK press industry. In the UK,press self-regulation is administered by the Press Complaints Commission(PCC) as a compromise borne out of the conflicting government objectivesto safeguard press freedom while protecting the individual from intrusive,defamatory and inaccurate reporting. The public good issue the industryfaces was expressed by former Royal Commission chairman David Calcuttas follows:

Effective self-regulation, if it could be achieved, would, I believe,be preferable to any form of statutory regulation. The problemis how to achieve it. The [...] press must accept that the re-straints necessarily involved [are] for the good of the industry asa whole; and that any short-term commercial advantage, gainedby a prurient scoop by one paper, could only lead to loss in thelong term for all (Calcutt, 1993, p.7).

Calcutt’s final report strongly criticized press self-regulation and calledfor the introduction of statutory laws, which was rejected by the UK govern-ment of the time. This instance in particular and the checkered history ofthe UK press generally betrays the reluctance of government here to intro-duce statutory regulation despite continual and substantive code breachesand consequent criticism of press self-regulation over the years (see Cal-cutt (1993); Frost (2000), pp.190, Hodgson (1993), pp.165, Gibbons (1998),pp.274). Intermittent but substantial public and governmental concern overthe effectiveness of the PCC and its precursors in securing industry compli-ance have so far failed to generate more formal governmental interventionas other industries have experienced. The reason may partly lie in the highpolitical cost associated with introducing statutory regulation to a power-ful and vociferous industry, which may additionally be interpreted as com-promising important pluralistic liberties in a traditionally liberal political

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culture (high R) (Gibbons, 1998, p.279). Frost (2000), for example, arguesthat direct legislation following a series of scandals involving members of theBritish royal family may have been averted by the imminent 1992 generalelection.4 In contrast, intermittent public demands for curbing the worstexcesses of press reporting can be partly assuaged by a high-profile self-regulatory system such as the PCC (high a). These observations point to acase of a partial tolerance regime.

In addition, an examination of press industry motives reveals the ex-istence of the Chicken Game here. Plentiful evidence points to the highcosts newspapers associate with the introduction of statutory regulation.In particular, anecdotal evidence would suggest that the relative benefit ofremaining free from statutory intervention is such that some parts of theindustry find it in their interest to support the regime unilaterally (B > C).One indicator is the relatively small size of the PCC’s budget of only 0.05%of the UK press industry’s total turnover (Press Complaints Commission,2003).

The analysis of the Chicken Game would lead us to expect partial compli-ance with the self-regulatory code of practice. This matches the experiencein the UK press industry. Compliance levels are generally thought to bedisappointing in comparison with other UK self-regulatory regimes such asadvertising (Calcutt, 1993; Hodgson, 1993; Gibbons, 1998; Frost, 2000)).In particular, in line with the reputation dimension of the game, a smallnumber of publications are significantly overrepresented in the adjudicationrecords of the PCC (Press Complaints Commission, 2003). This latter factmay be an indication of successful reputation building by some industrymembers.

3.3 UK Life Insurance as a Prisoner’s Dilemma

A possible application of the Prisoner’s Dilemma is the failure of self-regulationin the UK life insurance industry. Following the 1986 Financial Services Act,a government initiative led to the creation of a number of SRAs to mod-erate the conduct of firms in areas such as the distribution of long-terminvestment products, securities dealing and investment management. Thesewere potentially subject to opportunistic selling techniques based on asym-metric information between buyer and seller (Ennew and Devlin, 1993). Inthe life insurance industry, two such bodies resulted: the Life Assurance and

4The high political risk of a tough stance against the media was illustrated by thecircumstances surrounding the resignation of the minister responsible for the press, DavidMellor, amidst allegations regarding his personal life widely reported in the newspapers.

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Unit Trust Regulatory Organisation (LAUTRO) and the Financial Interme-diaries, Managers and Brokers Regulatory Association (FIMBRA). Thesewere charged with the regulation of the sale of investment-based life prod-ucts such as pensions and unit trusts (Goodhart et al., 1998).

In terms of financial services regulation, the Conservative UK govern-ment at the time of the 1986 Act was arguably following a partial toleranceregime. Firstly, the strong libertarian and free-market credentials of theThatcher administration made statutory regulation politically undesirable(high R). Conversely, the looming parliamentary elections in the followingyear made a costly statutory regime economically unattractive. An exam-ination of the motives of financial service providers points to the existenceof a classic Prisoner’s Dilemma in their interactions. The market for (tiedor independent) financial advice is highly competitive with a large numberof often small providers. Collectively, the industry as a whole can clearlybenefit from successful self-regulation to avert both direct intervention andloss of consumer confidence. As a result, individual compliance cost areoutweighed by the benefits successful self-regulation affords (B > C/2).However, in contrast to the Chicken Game, the large number and small sizeof many industry members makes the unilateral support of self-regulationby some infeasible (B < C). Low margins for sales staff and companiesprovide an additional, powerful motive for opportunistic financial advice(Gower, 1982; Ennew and Devlin, 1993). As a result, the industry’s collec-tive interest in self-regulation was undermined by individual incentives forfree-riding.

The self-regulatory regime ultimately failed. Neither LAUTRO nor FIM-BRA proved to be very successful in constraining the tendencies of oppor-tunistic (and frequently poorly-trained) financial advisors to recommendproducts offering maximum commission, rather than consumer satisfaction(Ennew and Devlin, 1993). This finding corresponds to the theoretical anal-ysis of the Prisoner’s Dilemma Game. Mutual cooperation is known to bemore problematic in large, fluctuating or decentralised groups where trustand reputation are difficult to establish (Axelrod, 1984; Olson, 1965). Theindustry’s collective failure to establish cooperation resulted in a highly pub-licised mis-selling scandal that not only contributed towards a decline in thepublic image of all life insurance organisations but also the effective end ofself-regulation (The Economist, 1994). From the mid-1990s, stricter regu-lations were enforced by a government-appointed statutory regulator, thePersonal Investment Authority.

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4 Conclusion

In this paper we have considered the possibility of successful industry self-regulation in terms of government motives and the resulting strategic pro-cesses governing individual firm compliance decisions. We have establisheda typology of self-regulatory regimes on the basis of alternative assumptionsconcerning these motives. These scenarios reflect different versions of thefree-rider problem which arise as a result of the interactions. We concludethe paper by discussing the scope for strategic behavior at the firm, industryand governmental levels.

From the governmental perspective, some scenarios yield no opportuni-ties for self-regulation, while in others the prospects are mixed. In games2 and 5, government faces an industry where the relation between the in-dividual firm’s costs and benefits of self-regulation is such that no volun-tary regime can succeed (B < C/2). In the alternative case, the prospectsfor successful self-regulation depend on government tolerance towards non-compliance. A zero-tolerance stance generates the Assurance Game. Here,mutual compliance can be engendered to everyone’s benefit using suitablecoordinating devices, such as an effective SRA. The case is more complexunder partial tolerance. As we have seen, the Chicken Game cannot beexpected to generate full compliance by the industry concerned. The mosttricky case arises in the Prisoner’s Dilemma. Here, the success or failure ofself-regulation depends on the ability of firms to establish collective actionon the basis of mutual trust.

These observations suggest that government has an incentive to gener-ate the expectation of a zero tolerance regime irrespective of its true inten-tions. A credible threat of statutory intervention following partial compli-ance transforms both the Chicken Game and the Prisoner’s Dilemma intothe more promising Assurance Game5. However, governments following thisapproach need to avoid a credibility gap as the one generated by the UKgovernment’s failure to legislate following a series of damning reports onpress self-regulation (Calcutt, 1993).

At the industry level, the SRA functions as a guardian of collective in-dustry interest against both government action and individual member freeriding. The difficulty of the self-regulator’s task depends on the game athand. In the Assurance Game, the SRA can act as an effective coordi-

5This kind of threat would serve to subtract the payoff of B from both players’ payoffsin the two outcomes associated with unilateral compliance (see figures 2 and 4). It canbe easily verified that this would generate Assurance Game payoffs for both Chicken andthe Prisoner’s Dilemma.

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nation device to secure the success of self-regulation in the interest of allparties. In the Chicken Game, the SRA cannot hope for more than a mix-ture of compliance and violation. On the other hand, government’s partialtolerance in this game erodes the SRA’s incentive to clamp down on non-compliance effectively. Note that the equilibria in the game afford a highercollective payoff for both firms than in any other game. The most chal-lenging case for the authority therefore arises in the Prisoner’s Dilemma.Here, the survival of self-regulation depends on the industry’s ability to es-tablish mutual cooperation. The SRA has a crucial role in this process andmay benefit from a number of strategies known to engender cooperation inthe game, such as enhancing the prospect for long-term interactions withinthe industry (Axelrod, 1984). Another alternative is the provision of selec-tive incentives for compliant members of the self-regulatory regime, such asan information-provision service, and/or a platform for lobbying and otherbusiness development opportunities (Olson, 1965).

Finally, there is scope for the use of strategy at the firm level. In theChicken Game, we may expect that some firms will attempt to establishreputations for unilateral violation in order to free ride on the restraint ofother industry members. In the Prisoner’s Dilemma, the scope for the use ofreciprocal strategies such as Tit-for-Tat has been well-documented (Axelrod,1984).

Self-regulation may be feasible depending on the particular motivationof government and industry, and on their ensuing strategic choices. An suit-able strategic analysis can therefore help in the consultation and assessmentprocess prior to the implementation of any proposed self-regulatory regime.

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