Optimizing Regulation of Electronic Commerce

The impressive growth of Internet markets has been accompanied by an important academic debate on how to regulate them. Commentators have suggested traditional top-down or bottom-up regulatory approaches based largely on ideological grounds. To date, there has been no rigorous analysis of the various proposals for e-commerce regulation. In this article, the authors analyze the advantages and shortcomings of each regime and propose a mixed solution that maximizes net social welfare. The authors first present a model of the institutional background of an economic system and provide evidence of its functioning on the Internet, which permits an evaluation of market functioning on the Internet as compared to real world markets. This evaluation indicates that the Internet is a system technologically different from real life markets, and thus government and private sector initiatives have a different impact on its structure. The authors also examine the economic and political implications of Internet regulation, discuss the various bottom-up and top-down approaches to this regulation, and conclude that a pure regulatory system is not viable and that a cooperative result is welfare improving. The authors then construct a game theoretic model in order to analyze the different regimes proposed for Internet regulation. Based on this analysis, the authors propose a new, optimal regulatory regime based on tacit cooperation between the government and private sector regulators and show how such a regime maximizes net social welfare for both consumers and firms and avoids the drawbacks of the top-down or bottom-up regulatory approaches. In this tacit, public-private cooperative solution, the authors identify a role for government in setting minimum baseline standards for problems such as online privacy, preventing the capture of private regulators through meaningful oversight, increasing the participation of firms in private regulatory initiatives, and also serving as the enforcer of last resort. Finally, the authors perform two, thorough case studies of private third-party regulation - regulation of online privacy by BBBOnLine and regulation of online consumer fraud by the Federal Trade Commission (FTC). The authors demonstrate how both private self-regulatory and top-down government regulation can be improved significantly by incorporating specific insights drawn from their optimal regulatory regime.