Leniency in private regulatory enforcement

Profit-seeking firms can present efficiency improvements when performing functions traditionally relegated to government. Yet these potential cost-efficiencies from market competition are often offset by poor enforcement quality resulting from moral hazard, which can be particularly onerous when outsourcing enforcement of government regulation. In this paper, we argue that the considerable moral hazard of private regulatory enforcement can be mitigated by the scope of organizations' product/service portfolios and by private governance mechanisms. These organizational characteristics affect the stringency of enforcement through reputation and customer loyalty, differential impacts of government sanctions, and standardization and internal monitoring of operations. We test our theory in the context of vehicle emissions testing in a state in which the government has outsourced inspection and enforcement to private sector establishments. Analyzing millions of emissions tests, we find empirical support for our hypotheses that particular forms of firm governance and product portfolios can mitigate moral hazard.