Title: What is the Objective of Professional Licensing? Evidence from the US Market for Lawyers. Author: Mario Pagliero

Transcription

1 Title: What is the Objective of Professional Licensing? Evidence from the US Market for Lawyers Author: Mario Pagliero Department of Economics and Finance University of Turin Cso Unione Sovietica 218bis Turin Italy JEL: L4, L5, K2 Keywords: professional licensing, legal market, bar exam This paper is competing for the young economist award.

2 What is the Objective of Professional Licensing? Evidence from the US Market for Lawyers Mario Pagliero March 11, 2005 Abstract This paper investigates the effects of professional licensing. Two theories are compared. According to public interest theory, professional licensing solves the lemons problem generated by asymmetric information. In contrast, capture theory predicts that licensing aims at increasing professional salaries by restricting supply. The empirical strategy is based on a model of licensing. A newly constructed data set on lawyers licensing exam difficulty, candidate quality and exam results allows to distinguish the alternative theories. Public interest theory is rejected in favor of capture theory. The results imply that professional licensing has a significant effect on entry salaries. On average, licensing increases annual entry salaries by more than $10,000. This implies a total transfer from consumers to lawyers of 19% of lawyers wages and a total welfare loss of over $3 billion. JEL: L4, L5, K2. Keywords: professional licensing, legal market, bar exam. University of Turin, Department of Economics and Finance, C.so Unione Sovietica 218bis, Turin, Italy; mario.pagliero@unito.it. London Business School, Department of Economics, Regent s Park, London, NW14SA, UK. 1

3 1 Introduction Entry in a large number of professions requires permission of state licensing boards and demonstration of some degree of competency. In addition to lawyers, the focus of this paper, examples include accountants, auditors, teachers, nurses, engineers, psychologists, barbers and hairdressers. According to Kleiner (2000), more than 800 occupations are licensed in at least one U.S. state. Professional licensing directly affects 18 percent of U.S. workers, more than the percentage affected by either minimum wage or unionization. Professional licensing has been the subject of academic and political debate over the past few decades. Evaluating the impact of policy reform proposals hinges on understanding the objectives pursued by licensing boards. According to licensing stated objectives, minimum standards are set as a function of the technical characteristics of the profession, its complexity, and the need to protect consumers from unqualified practitioners. There are two main competing theories of licensing. The first may be labeled public interest theory. Building on the work of Akerlof (1970), Leland (1979) showed that professional licensing might remedy the market failure derived from asymmetric information. In markets where consumers cannot observe the quality of professionals, the social planner could increase welfare, with respect to the free entry equilibrium, by imposing a minimum quality standard. The optimal minimum standard trades off the quality-enhancing and the competition-reducing effects of licensing. The second view is capture theory. Capture theory, pioneered by Stigler (1971), argues that regulation is acquired by the industry and is designed and operated primarily for its benefit. This second approach implies that professional examinations are intended to limit the number of professionals, increase prices, and weaken competition, thereby introducing the typical inefficiencies caused by market power. This paper shows that these two theories can be empirically distinguished using data on the market for lawyers. The two views of licensing are compared within a simple model that provides clear testable implications. Testing the predictions of the two approaches requires data on licensing exam difficulty, candidate quality, exam results and lawyers 2

4 salaries. All this information is available for the legal market. The key feature of this data is that exam difficulty and candidate quality can be measured and compared across states and years. Constructing the data set required studying in detail the grading procedures in each state. The data on candidate quality was collected directly from state licensing boards. This data set provides the first systematic evidence on licensing exam difficulty and candidate quality. The first result of the paper is that exam difficulty increases in periods of low demand and when the number of candidates and their quality increase. In addition, states with more and better candidates have more difficult examinations, other variables being equal. This implies that licensing boards do not set absolute standards. Rather, minimum standards depend on market conditions. The model shows that both public interest theory and capture theory predict this result. In fact, simple reduced form arguments do not distinguish the two theories. To separate them, one must compare the first order condition of the social planner with that of the captured regulator. According to public interest theory, the social planner optimally trades off the welfare increasing effects of admitting one additional candidate with the social cost of lower standards. The social cost is due to the fact that consumers valuation decreases with the observed minimum standard. Under capture theory, instead, the regulator attempts to maximize salaries within the profession. In addition to the effect of minimum standards on consumers valuation, such a regulator takes into account that admitting one additional candidate decreases wages for existing members of the profession. This second effect crucially depends on the market size. Differences across states and years in candidate quality, number of candidates, demand level and market size allow to identify the two theories. In contrast with consumer protection theory, capture theory implies a positive cross sectional correlation between salaries in the legal market and number of candidates passing the exam divided by the market size. This difference between the predictions of the two theories provides a clear test of the null hypothesis of public interest theory against the alternative of capture 3

5 theory. The main result of the paper is that welfare maximization is rejected in favor of capture theory. The estimated coefficients allow to compute the difference between the observed entry salary in the legal profession and the unobservedoutsidesalary. Onaverage,yearlyentry salaries are estimated to exceed the outside option by more than $10,000 (2002 USD). This implies significant transfer from consumers to lawyers. I estimate that the total transfer is over $6.6 billion (2002 USD), or 19% of the entry salary. The results imply a total welfare loss of over $3 billion (2002 USD). The empirical literature on licensing has clearly established that entry restrictions significantly affect market outcomes. However, understanding the true objective of licensing remains an open issue. Starting with the pioneering work of Maurizi (1974), the empirical literature on licensing has focused on its indirect consequences. On the one hand, there is some evidence in favor of capture theory. Using data on the lawyers market, Pashigian (1979) finds that licensing reduces lawyer mobility and Tenn (2000) shows that when mobility is lower wages tend to be higher. Using data on other professions, Shepard (1978), Haas-Wilson (1986), Kleiner and Kudrle (2000) and Kugler and Sauer (2005) find evidence that regulation increases prices without significantly increasing quality. On the other hand, there is evidence that licensing is related to asymmetric information. Leffler (1978) finds that minimum standards tend to be higher where consumers costs of determining professionals quality are higher. Law and Kim (2004) find that licensing was adopted earlier in occupations in which informational asymmetries were more relevant. They also show that in some professions licensing did not raise salaries but may have increased quality. 1 This paper is organized as follows. Section 2 describes the licensing stated objectives in the legal market. Section 3 compares the public interest theory and capture theory. Section 4 describes the data. Section 5 discusses the identification of the two theories. Section 6 discusses the empirical results. Section 7 concludes. 1 The legal literature has not reached a consensus on the causes and consequences of professional licensing either (Curcio 2002, Merrit, Hargens and Reskin 2001, the American Association of Law Teachers 2002, Perlman 2004). 4

6 2 Licensing Stated Objectives The key features of the licensing stated objectives are the absolute quality standards that are guaranteed by the regulator. The American Bar Association and the National Conference of Bar Examiners (2003) summarize this as: The public interest requires that the public be secure in its expectation that those who are admitted to the bar are worthy of the trust and confidence clients may reasonably place in their lawyers. This motivation for entry regulation is common across all states. For example, the Rules for Admission to the Minnesota Bar (as of January 1, 2003) state that the examination exists... to ensure that those who are admitted to the bar have the necessary competence and character to justify the trust and confidence that clients, the public, the legal system, and the legal profession place in attorneys. Standards are set to protect the public, not to limit the number of lawyers admitted to practice (the American Bar Association 2003). Rather, the standards set by...bar exams are used to screen out those who are not competent to practice. While not perfect, the bar exam represents the state high courts commitment to protecting the public [...] (Corneille 2001). This licensing justification is common and generally accepted by the public, although it is often vaguely stated. 3 Capture Theory and Public Interest Theory Both capture theory and public interest theory are fundamentally affected by market variables. Such variables include the level of demand for legal services along with the number and overall quality of candidates. These theories can therefore both be labeled entry regulation theories. Although they share this quality, these two theories are different and yield different predictions. In this section, I distinguish the two by developing a stylized model that encompasses the essential features of both. The model takes as exogenous the candidate quality distribution, the number of candidates and the aggregate demand function. The licensing board sets the exam difficulty, which determines the pass rate and the market salary. The model shows the key role played by two observable variables: 5

7 The number of candidates and the market size. Consider a state in which there is a licensed profession (the legal profession) and a competitive non-regulated profession. Assume there are N candidates, each with quality q randomly drawn from the continuous distribution F (q, q 0 ), with mean q 0. Consumers do not observe the quality of the professionals but rely on available public information. Following Akerlof (1970) and Leland (1979), the demand for legal services is a function of a quality summary statistic. I assume that the demand depends on the minimum quality allowed in the market q. Consumers, thus, value the services offered based on this minimum quality level, which they can observe via the entry examination difficulty. The aggregate inverse demand function is w d (l, q) =a 1 + a 2 q a 3 l Z + a 4Y (1) where w is the wage of a lawyer; l is the number of lawyers; Y is an exogenous variable affecting the level of demand and l/z is the number of lawyers per consumer. When a 2 equals zero there is no asymmetric information, as in the classic capture theory. All candidates with quality at or above the threshold q choose to enter the legal profession. All others accept the outside salary w 0 of the non-regulated market (assumed to be sufficiently low as to always be the second best option). 2 Given the distribution of candidates F (q, q 0 ), there is a direct relationship between the number of professionals admitted and the examination difficulty. Assuming no uncertainty in the examination process, the exam can precisely reveal each candidate s quality. The pass rate can then be written as l/n =1 F (q, q 0 ). Therefore, the exam difficulty, q, can be written as a decreasing function of the number of candidates passing the examination: q(l) =F 1 (1 l N,q 0). (2) 2 Differently from Leland (1979), this model emphasizes the effectofnumberofcandidates,theirquality and demand level. These are important variables for the empirical analysis that follows. The model also allows for a generic distribution of candidate quality. However, this model simplifies the model of Leland (1979) by assuming that the outside option salary is not a function of candidate quality. 6

8 Social Planner The supply of lawyers is regulated by the licensing board. The social planner aims to set the examination difficulty (or equivalently the number of candidates to be admitted) in order to maximize W (l, q) = Z l 0 wd (l 0, q(l)) w 0 dl 0. (3) The problem of the social planner is Max l W (l, q(l)), and the first order condition for the planner is a 1 + a 2 q(lp) lp a 3 Z + a dq(lp) 4Y + a 2 lp w 0 =0, (4) dl where l p is the welfare maximizing number of passers. The social planner equates the marginal social gain with the marginal social cost of increasing the number of candidates passing the exam. dq(l) dl is the marginal change in difficulty required to allow an additional candidate to enter the profession. The marginal effect dq(l) dl is negative, as a higher pass ratecanonlybeachievedbyeasierexaminations. Themarginaleffect dq(l) dl depends on the candidate quality distribution and the number of applicants: dq(l) dl = 1 1 f(q,q 0 ) N (where f(q(l),q 0 ) is the probability distribution function of candidate quality evaluated at q(l)). The optimal number of passers determines the market salary w p(l p, q(l p)). Therefore, welfare maximization implies wp(l p, q(lp)) 1 = w 0 + a 2 f(q(lp),q 0 ) N. (5) l p The intuition for the second term in (5) is simple. From the point of view of the social planner, admitting one additional candidate by decreasing the standard has a social cost. This is because consumers valuation is based on the observed minimum standard. This effect is stronger if the number of candidates is low. This effect also depends on where the 7

9 quality of the marginal candidate is located in the distribution of quality. Lower density of the distribution of candidates implies larger effect on minimum quality and therefore on salaries. Captured Regulator According to capture theory, the regulator behaves as a cartel, maximizing lawyers profits. Extra profits can be written as the difference between market salary and the competitive outside salary w 0, Π(l, q) =[w d (l, q(l)) w 0 ] l. State boards choose the examination difficulty q or equivalently the number of candidates allowed to enter the market. 3 Therefore, the problem of the captured regulator is Max l Π(l, q(l)), and the first order condition for the captured regulator is a 1 + a 2 q(lc) lc 2a 3 Z + a dq(l 4Y + a c) 2 lc w 0 =0. (6) dl where l c is the optimal number of candidates admitted in the profession. The captured regulator equates the marginal increase in lawyers salaries with the outside option w 0. The marginal increase in lawyers salaries is decreasing in the number of lawyers admitted in the profession for two reasons: First, a larger number of lawyers directly implies lower salaries, as the inverse demand is decreasing in l Z. Second, a larger number of passers implies lower standards, which causes a decrease in consumers willingness to pay. The optimal number of passers determines the market salary w c(l c, q(l c)). Therefore, 3 Alternative assumptions on the objective of professional boards are possible. In particular, licensing boardsmaygivemoreweighttoprofits of particular groups of professionals. In the absence of evidence on the issue, the captured regulator is assumed to give equal weight to each professional. 8

10 capture theory implies that wc(l c, q(lc)) lc = w 0 + a 3 Z + a 1 lc 2 f(q(lc),q 0 ) N. (7) Note that the only difference between (7) and (5) is the existence of the term l c Z.From the point of view of the captured regulator, admitting one additional candidate has two separate effects on salaries. The first is the effect of minimum standards on consumers valuation. The second is that admitting one additional lawyer implies lower wages for all lawyers. This is due to the fact that consumers marginal valuation is decreasing in the number of lawyers in the market. For the captured regulator, the marginal effect of one additional lawyer on salaries crucially depends on market size. Equation (7) distinguishes the two theories. Take a number of states that differ in N, q 0, Z and Y. Capture theory predicts a positive correlation between market salary and number of passers divided by market size. Solution Figure 1a and 1b illustrate the model when a2 > 0 (positive effect of minimum standards on demand) and a 2 =0(no effect of minimum standards on demand) respectively. The point C describes the optimal choice of the captured regulator and the point P corresponds to the choice of the social planner. The point F is the free entry equilibrium, in which the salary in the regulated profession is equal to the outside option salary. When a 2 =0the efficient outcome P corresponds to the free entry equilibrium F.Thesolution of the model exists and is unique for both the captured regulator and the social planner if the candidate distribution satisfies the regularity condition 1 f(q) l f(q) 2 q N condition is clearly verified for the uniform distribution of scores (for which f(q) q is also verified for the more realistic normal distribution of scores. +1> 0. This =0). It The number of lawyers admitted to the profession determines the examination difficulty through (2). I denote by q(l c(n,q 0,Y,Z,w 0 )) and q(l p(n,q 0,Y,Z,w 0 )) the exam difficulty set by the captured regulator and by the social planner respectively. It is easy to show that l c <l p and q(l p) < q(l c). The social planner optimally balances the utility 9

11 enhancing effects and the competition reducing effects created by higher standards. The captured regulator, however, sets a standard that is too high with respect to the social optimum and therefore fails too many candidates from the social point of view. Comparative Statics The comparative statics of the model provide predictions for how exam difficulty should depend on market conditions. However, these results do not distinguish the two theories. In fact, the sign of the partial derivatives of exam difficulty with respect to the exogenous variables is the same for both theories. First, both capture theory and welfare maximization predict that the exam difficulty increases as the level of the demand function decreases ( q(l c ) Y < 0 and q(l p ) Y < 0), other variables being constant. Figure 1.b illustrates the equilibrium in the w and l space when a 2 =0. A demand shock Y < 0 leads to a lower optimal number of admissions and therefore to a more difficult examination. The opposite is true for Y > 0. Entry regulation implies that standards increase during recessions. Looking at cross-sectional data, everything else being equal, states with higher demand for legal services should have easier examinations. Second, standards increase as the number of candidates, N, and their average quality, q 0,increase( q(l c ) N > 0; q(l p ) N > 0; q(l c ) q 0 > 0; q(l p ) q 0 > 0). This is because candidates are randomly drawn from a given distribution. As N increases or the distribution of candidates shifts towards higher levels of quality, the optimal number of passers can be achieved with a higher standard. This implies that states with relatively more candidates, or better candidates, should have more difficult examinations, other variables being equal. Third, the exam difficulty decreases as the number of consumers, Z, increases ( q(l c ) Z < 0 and q(l p) Z < 0). When the market size increases, the optimal number of candidates to be admitted increases. difficulty must decrease. Therefore, holding constant the pool of candidates, the exam This implies that, other variables being equal, larger states should have easier examinations. Fourth, the exam difficultyisincreasingintheoutside option w 0 ( q(l c ) w 0 > 0 and q(l p) w 0 > 0). As the outside option increases, the number of 10

12 candidates to be admitted to the profession decreases both for the captured regulator and the social planner. Other variables being constant, this implies that states with higher outside salaries should have more difficult examinations. 4 Data The bar exam structure is the same for almost all states and has remained stable over the past two decades. The bar exam is administered twice a year, in February and July. 4 The exam consists of the Multistate Bar Examination (henceforth MBE), a standardized test, and essay and case questions. Since 1981, all but two states (Louisiana and Washington) have used the MBE as part of the bar examination. The MBE contains 200 multiple choice questions developed by the National Conference of Bar Examiners. The MBE is also corrected by the National Conference of Bar Examiners. Using the results of a small sample of questions, which are repeated in different examinations over time and across states, scores are scaled so that any MBE score represents the same level of performance, irrespective of when and where the exam is taken. Results can therefore be compared across states and years. 5 Essay and case questions are set by state boards and graded at the state level, according to criteria set by each board. 6 Therefore, the same score does not necessarily correspond to the same level of performance across states and years. However, most states have introduced essay score scaling. The most common scaling procedure is mean and variance scaling. Mean and variance scaling requires that each essay score is transformed so that the mean and variance of the distribution of scaled essay scores is equal to the mean and variance of the standardized test scores. The scaled essay scores are 4 Exceptions are Delaware, Nevada and North Dakota, where the bar exam is held only once a year. 5 A more detailed description of the MBE can be found at A similar standardized test is the Graduate Record Examination (GRE), often used in the admission process to economics graduate courses. 6 Some states have recently started to use essay and case questions developed by the National Conference of Bar Examiners (known as Multistate Essay Examination and Multistate Professional Test). When this is the case, the Conference provides to state boards possible exam questions and some analysis of the issues involved in each question in order to facilitate the grading. Even when using this service, state boards grade the answers independently, using standards set locally. 11

13 therefore not affected by exam specific unobserved differences in the exam difficulty or in the severity of grading procedures (Crocker and Algina 1986, Linn 1993). 7 The overall scores (weighted average between standardized test and essay test score), then, have the same metric across states and years and can be compared. Since the passfail decision is based on overall scores, the observed minimum quality standards for each state share a common metric and provide a simple measure for the exam difficulty. 8 The main source of standard and grading procedure data is The Comprehensive Guide to Bar Admission Requirements, published annually by the American Bar Association and the National Conference of Bar Examiners. This source is complemented by information from various issues of The Bar Examiner, published by the National Conference of Bar Examiners. Data on minimum quality standards is available from either 1984 or the introduction of comparable standards (reported in Table I, column 1), whichever is later, to Table I, column 2 reports any changes in the minimum quality standards while Column 3 reports the corresponding date of each change. Column 4 reports the minimum quality standard in the last year of the sample. With this information, Table I is sufficient to reconstruct the time series of the minimum standard in each state. 9 Table I shows that standards differ across both states and years. Differences in standards are very significant. Using for comparison the average distribution of MBE scores in the US (over the period ), changes in the difficulty from the level of Alabama to the level of California imply a drop in pass rate from 79% to 39%, equivalent to more than 22,000 additional candidates per year failing the examination. 10 Changes in standards, however, 7 An alternative scaling procedure is quantile by quantile equating. The results of the two techniques are not necessarily the same but differences are empirically small (see Lenel 1992). 8 The weights given to the two exam components may vary across states. Empirically, the weight given to the standardized test varies between 50 percent and 65 percent. These differences may affect the variance of overall scores. For realistic distribution of scores and standards, however, these differences do not affect the comparability of minimum standards. 9 When standards are comparable, but not expressed on a points basis, I transformed the standards to a basis to increase the consistency of Table I. In the Comprehensive Guide there is some uncertainty over when some standards changed. Where possible I used additional sources to locate the exact date of change. In the cases in which none was available and uncertainty persisted, I used the earliest date compatible with the information in the Comprehensive Guide. 10 I use for comparison a normal distribution with mean equal to the mean MBE score and variance equal to the mean variance in the US for the period Figures on passers are based on 60,000 candidates per year. Evidence on the average distribution of scores is provided by Case (2003). 12

14 are infrequent and relatively small with respect to differences across states. In fact, about 77% of the variability in standards is across states. Minimum quality standard data is matched with the number of takers and passers in each examination, provided by the National Conference of Bar Examiners. Differently from data on exam difficulty, data on exam results is available from 1981 to Table I, column 5 reports the average number of candidates taking the bar examination in each state while column 6 shows the average pass rate for each state. My data set also includes data on MBE scores. The data consists of national US average scores and the standard deviation of the national distribution ofscores,foreachexamination,from1981 to I also integrated the data with information on mean MBE scores at the state level, for each examination. I collected this information from the Bar Association or the Supreme Court office responsible for administering the exam. States vary in data disclosed. Table I, columns 7 reports the availability of data for each state and column 8 reports the average MBE score by state. The data also includes information on entry level salaries of law school graduates in both law firms and business sector. Entry in law firms is clearly conditional on passing the bar exam. The National Association for Law Placement surveys law school graduates one year from graduation and collects data on mean and median salary by sector of employment Identification and Empirical Strategy 5.1 Distinguishing the Stated Objectives from Entry Regulation Theories Entry regulation theories predict that number and quality of candidates, demand level and market size affect state board decisions. The model predicts the sign of the effect of these variables on the board behavior. Estimating the reduced form equation for q provides a test of the impact of market variables on the minimum standards. If these 11 Data is published annually in Jobs & J.D. s: Employment and Salaries of New Law Graduates, National Association for Law Placement. Data for the classes from 2000 to 2003 show that virtually all jobs in law firms require passing the bar examination. 13

15 variables do in fact significantly impact exam difficulty, then the existence of absolute standards would be rejected. This would imply that state boards set relative minimum standards, as predicted by public interest theory and capture theory. The basic empirical specification is q i,t = b 0 + k t + b 1 q 0,i,t + b 2 N i,t + b 3 Y i,t + b 4 Z i,t + X i,t b 5 + u i,t (8) where q i,t is the exam difficultyinstatei and year t; q 0,i,t is the average MBE score; N i,t is the number of candidates taking the bar examination; Z i,t denotes the population of the state, used as a proxy for the size of the market; Y i,t denotes the Gross State Product per capita 12 ; k t is a dummy variable for year t; u i,t is the error term. The matrix X i,t includes the educational attainment and the fraction of immigrant population in the state, as suggested by Leffler (1978). The reason is that consumers with lower education and less local knowledge should require more protection from the regulator, and therefore higher minimum standards. Estimation results are described in Section Endogeneity Candidates may react to changes in the exam difficulty. This introduces endogeneity issues in the variables N and q 0 in model (8). Since candidates can choose in which state to take the bar exam, an increase in difficulty in one state may provide incentives to take the bar exam in another state, with an easier examination. Therefore higher standards may decrease the number of candidates. This incentive may be particularly strong for low quality candidates, who are most affected by changes in exam difficulty. Thus, higher standards may increase candidate quality. If the first effectweresignificant in my sample, then the OLS estimates of the effect of the number of candidates on the exam difficulty would underestimate the true effect. 12 Using aggregate data for the US, Pashigian (1977) identified Gross Domestic Product as the main demand shifter in the market for lawyers. 13 Under the assumption that the real outside option for a lawyer is the salary in a competitive non regulated market, there is no need to control for differences in outside option salary across states. 14

16 If the second effect were significant, then OLS estimates would overestimate the effect of candidate quality on the exam difficulty. Differences in difficulty may also affect candidates behavior through their effect on salaries. Differences in salaries may change the number of applicants and shift their quality distribution. In Section 6, I first look for evidence of candidates response to changes in standards using both aggregate and state level data. I do not find clear evidence of large endogenous response of the number of candidates or their quality. In addition, I also estimate model (8) using instrumental variables. The instrumental variables approach is based on some specific features of the US market for lawyers. After graduation, candidates can freely choose where to take the bar exam. In addition, there is no advantage in taking the bar exam in the state where one graduated. This is because the bar exam is based on the fundamental legal principles and not on local law. 14 This has two implications. First, law school quality and reputation, rather than bar exam difficulty or salaries, are the most relevant variables in determining law school choice. Second, given that candidates can move across states, differences in the size and quality of lawschoolscannotbeeffectively used to regulate entry at the state level. 15 This suggests to use the ranking of law schools, the quality of law school students matriculated and the number of law school graduates as instruments for the quality and number of bar exam candidates. The results of instrumental variable estimation, described in Section 6, suggest that endogeneity does not play a big role in the data. 5.2 Distinguishing Public Interest from Capture Theory When looking at how exogenous variables affect the equilibrium level of difficulty, number of passers and professionals quality, public interest theory and capture theory are obser- 14 IntheCodeofRecommendedStandards,theAmerican Bar Association and the National Conference of Bar Examiners (2003) point out that "in selection of subjects for bar examination questions, the emphasis should be upon the basic and fundamental subjects that are regularly taught in law schools". Moreover, "questions should not be based on unusual or unique local case or statutory law, except in subjects with respect to which local variations are highly significant and applicants are informed...". 15 This does not exclude that nation-wide educational standards may be used to regulate entry at the national level. Educational requirements to enter the legal profession do not vary significantly across states. 15

17 vationally equivalent. 16 In spite of these similarities, public interest theory and capture theory can be distinguished using (7) and (5). The key insight from the model is that, under capture theory, the optimal salary is increasing in l/z. However, under public interest theory, the optimal salary does not depend on l/z. In order to distinguish the two theories, I focus on the market for entry level lawyers. This approach has several advantages: First, the number of passers correspond to the number of first year lawyers in the market. Second, board decisions directly affect entry salaries. Third, entry level salary data is available from the National Association for Law Placement for both law firms and the business sector. Since entry in the business sector is not regulated, salaries in business are not affected by the bar exam difficulty. Consider I states, i =1,...,I,andT years, t =1,..., T. Each state and year differs in the number of candidates N i,t, their quality q 0,i,t, themarketsizez i,t, the level of demand Y i,t, the outside salary w 0i,t and the exam difficulty q i,t. Having detailed data on the number of candidates passing the bar exam, it is possible to compute e l i,t = l i,t Z i,t, where Z i,t is the population of the state. I can also compute the pass rate l i,t N i,t for each state i and year t. Further, having information on the score distribution, it is also possible to compute the ratio 1/f(q, q 0 ) i,t. 17 Therefore, under capture theory, I can write the salary as w i,t = w 0i,t + β 1 e li,t + β 2 ep i,t + ε i,t (9) where w i,t denotes the entry salary in the market for lawyers; w 0i,t the outside option; e li,t = l i,t Z i,t ; ep i,t = 1 l i,t f(q,q 0 ) N i,t and ε i,t is the error term. The two competing theories can be empirically distinguished by estimating the parameters β 1 and β 2. Since there is both a strong expectation and empirical evidence (Pashigian 1977) that 16 In addition to the comparative static results described above, note that higher standards always imply higher quality passers, whether or not the higher standards were designed for the public good. To the extent that exam results have some correlation with individual quality, higher entry requirements imply higher quality of those who enter the profession irrespective of the board s objective. 17 Since exam results tend to be approximately normally distributed, I can write the probability distribution function as f(q, q 0 )=g(g 1 (1 l, 0, σ), 0, σ),whereg and G are the normal probability N distribution function and cumulative distribution function respectively, with mean zero and variance σ. Empirical evidence on the normality of score distributions and the score variance is provided by Case (2003). 16

18 demand for legal services is less than perfectly elastic, the coefficient a 3 in (1) is expected to be different from zero. It follows from (7) that the coefficient of e l is zero under public interest theory and strictly positive under capture theory. Under the assumption that the observed data are outcomes of either capture theory or welfare maximization, testing the restriction β 1 =0tests the null hypothesis of public good versus the alternative of capture theory. Outside Option Since the two competing theories differ mainly with respect to the difference between lawyers salary and the outside option, it is important to control for the unobservable outside option w 0. The main variable used to control for heterogeneity in outside option is the entry salary of law school graduates in the business sector. Assume that the outside option for a lawyer entering the profession is a monotone function of the entry salary in the business sector, w 0,i,t (w bus,i,t ). Assuming linearity, w 0,i,t = k 0 + k t + γw bus,i,t (10) where w bus,i,t is the business entry salary in state i and year t; k 0 is a constant that captures the systematic differences between the outside option salary and w bus,i,t. The term k t allows the difference between the outside option salary and the observed salary in the business sector to vary across time. This captures the effect of any unobserved variable that may affect over time the outside option. This includes imperfectly synchronized business cycles in the legal and business markets along with different growth rates in sector productivity. Empirical Specification If there is no asymmetric information in the market (a 2 =0), then estimating the first order condition w i,t = k 0 + k t + γw bus,i,t + β 1 e li,t + ε i,t (11) provides a test of public interest versus capture theory. The null hypothesis is β 1 =0 17

19 and the alternative β 1 > 0. As discussed above, the legal market may be characterized by asymmetric information. As such, the exam difficulty may affect consumers behavior. Assuming there are such effects on demand, then a 2 6=0and the first order condition can be written as w i,t = k 0 + k t + γw bus,i,t + β e 1li,t + β 2 ep i,t + ε i,t (12) Capture theory and welfare maximization can still be distinguished by testing β 1 =0. The problem of identifying the two licensing theories is somewhat analogous to that of identifying market power with market level data, as discussed by Bresnahan (1982 and 1987). Under capture theory, the licensed profession exploits its market power by reducing the entry flow of professionals in order to create rents for its members. This is analogous to a monopolistic industry in which output is reduced to increase profit margins. As in the problem of identifying market power, it is not possible here to distinguish alternative theories using simple reduced form arguments. However, there is an important difference between the two applications. The number of lawyers admitted depends on the quality and number of candidates. This affects the board first order conditions and clearly distinguishes the licensing problem. Endogeneity and unobserved differences in working environment There are a number of unobserved variables that affect both the salary in the legal market and the outside option salary. One such variable is the cost of living, which may differ across states. Differences in taxation, state economic development, business cycle, technology adoption and productivity also affect salary in the legal profession and the outside salary. The existence of large corporations may also affect both the entry salary in the legal market and the outside option. These variables can be described as unobserved differences in working environment, defined as v i,t,. Assuming that the effect of v i,t is linear, both for the salary in the legal market and in the business sector, then w i,t = k 0 + k t + γw bus,i,t + β 1 e li,t + β 2 ep i,t + v i,t + ε i,t (13) 18

20 and w bus,i,t = δ 0 + δ t + δ 1 v i,t. (14) Substituting for v i,t, model (12) can be written as w i,t = k k 0 t + γ 0 w bus,i,t + β 1 e li,t + β 2 ep i,t + ε i,t, (15) where k0 0 = k 0 δ 0 /δ 1 ; kt 0 = k t δ t /δ 1 and γ 0 = γ +1/δ 1. Therefore, including w bus,i,t in model (11) and (12) controls for differences in working environment. Thus, β 1 can be consistently estimated. However, one cannot infer the parameter γ, but this coefficient has no interest in testing alternative theories of licensing. 18 A second source of endogeneity comes from the fact that the variables e l i,t and ep i,t are function of l i,t and q 0,i,t, and candidates may choose where to take the bar exam according to the exam difficulty and expected salary. As discussed in the previous section, the robustness of the OLS results can be assessed using instrumental variables. Exogenous variation in the number and quality of candidates is provided by differences in the number of law school graduates and law school quality. Estimation results are described in the next section. 6 Results 6.1 The Timing of Standard Changes This section provides some preliminary descriptive results on licensing board behavior. The period , marked by two vertical lines in Figures 2-6, saw a general increase in the bar exam difficulty. Figure 2 reports the average observed change in standards for each year. Average change is the simple average of those changes reported in Table I. The increase in standards averaged 1.3 on the MBE scale for each year during this period, compared to -0.4 in other years. Over 80 percent of all observed changes occurred during the period Figure 3 reports the frequency of states that changed 18 The linearity assumption can be relaxed using higher order polynomials of w bus,i,t in (15). 19

21 their standard in each year. The yearly frequency is computed as the number of states changing standards over the total number of states for which standards were comparable. On average, 10 percent of the states changed their standard in each year during the period Only 2 percent changed their standard in each year during the remaining years from Increases in exam difficulty are clustered in years of recession. The period of increasing standards ( ) is a period of low (or negative) growth rates in the legal profession. Figure 4 reports the 3 years moving average of Gross Domestic Product growth rate in the legal services industry. There is a marked decline in this average growth rate at the beginning of the 90s. The industry s average growth rate declined below 0.1 percent in 1990 and remained below that level until The average growth rate during this period is -0.4 percent per year. In the remaining 12 years, both before and after, the industry has grown at an average rate of 4.3 percent per year. Since the business cycle across states may not be perfectly synchronized, Figure 4 may hide some state heterogeneity. While this could imply that standards changed at a different point of the cycle, the data reject this hypothesis. Standards were indeed changed during a period of declining growth rates. Figure 7 describes all states which increased their standards during the sample period. The first change in standards is denoted by year t =0. Figure 7 reports the average growth rate of Gross State Product in the legal services industry for year t =0and for the five years preceding and following the change. During this 11 year window, the growth rate of Gross State Product in the legal industry declined from 4% to -2%. Figure 7 also reports for each year the interval which contains 60% of the state growth rates. The evidence on standard changes is not consistent with absolute standards. However, the data is easily explained by entry regulation models. Under both capture theory and public interest theory, one should expect standards to increase in periods of recession. Candidates quality was high as standards increased between 1990 and As men- 19 The data used for computing the changes frequency includes some instances in which a clear change in the grading can be identified, but its sign and magnitude cannot be measured. Table I describes these cases. 20

22 tioned, a good measure of such quality is the average Multistate Bar Examination score. Figure 5 shows the mean MBE score of candidates taking the bar exam in the US for the period After a period of stability through the late 80s, the MBE average score increased and peaked in It then declined in the late 90s. This increase in quality affected the average pass rate, which moved from 65 percent in 1984 to 74 percent in 1994 (this is also reported in Figure 5). In spite of the higher quality, pass rates in 2000 fell to the level of This stems from the significant increase in exam difficultyinthe90s, coinciding exactly with the quality peak. 20 The number of candidates increased dramatically during the mid 90s as well. Figure 6 reports the total number of candidates taking the bar examination in the US for the period The number of candidates per year increased dramatically between 1990 and The exam difficulty increased during the same years in which the number and quality of candidates increased. This additional evidence cannot be explained by absolute standards. It can, however, be easily explained by entry regulation models. According to the model developed above, during the mid 90s three factors jointly pushed towards a generalized increase in standards: the legal market was in recession, the number of applicants increased and also their quality dramatically increased. 6.2 Determinants of Standard Heterogeneity In this section, I estimate the reduced form model for exam difficulty, aiming to test the entry regulation model predictions. The basic empirical specification is given by model (8) in Section 5.1. Table II reports summary statistics for each variable. Table III, column 1, reports the OLS estimation results. All the estimated coefficient signs are those predicted by the entry regulation models. The estimated coefficients for q 0,i,t and N i,t are both positive and significantly different from zero at conventional levels. This implies that more difficult examinations are observed in states with higher quality 20 While the mean MBE scores changed, the variance of their distribution did not show systematic variations over the sample period. Changes in pass rates cannot be attributed to changes in the distribution variance. 21

23 and more numerous candidates. significantly different from zero. The coefficients of Y i,t and Z i,t are negative but not Column 2 includes year specific indicator variables. Results are not affected significantly. Column 3 includes the educational attainment and the fraction of immigrant population in each state as additional regressors. 21 According to the exam stated objectives, as noted by Leffler (1978), a high educational attainment and a low fraction of immigrant population should require a lower minimum standard. The coefficients of these two variables are both non significant. Results in Table III show that absolute standards cannot explain standard variability. The public interest theory and capture theory, however, can explain this. These results confirm the evidence on standard changes presented in the previous section. Endogeneity At the aggregate level, no striking evidence exists in favor of a large endogenous candidate response. Figure 5 and 6 show that the number of candidates did not decrease and that average quality did not increase following the increase in standards in the 90s. Candidate quality actually returned to the levels of the mid 80s. 22 Table IV reports the instrumental variables estimation results. Coefficients are not significantly different from OLS estimates, as documented by the C-statistics. However, standard errors are larger than in Table III, particularly for the coefficient of the number of takers. The table also reports the J overidentification test, which does not reject the validity of the overidentifying restrictions. The mean 25th and 75th LSAT score percentiles for each state are used as instruments 23. For each state, the mean scores are computed as the weighted average of Educational attainment is the fraction of population aged 25 or over with a bachelors degree or higher qualification (Census Bureau, Current Population Survey). The fraction of immigrant population is the number of tax exemptions for people who moved to the state within the year relative to the total number of tax exemptions. Both immigration from other states in the US and from other countries is included (Internal Revenue Service). 22 At the state level, I study specific cases of changes in standards and I measure the change in number and quality of candidates after each change. I focus on instances of observed changes in standards. There is some evidence that increases in standards are followed by decreases in candidate number. However, in the only case in which I can observe the average MBE scores of candidates both before and after the change, I find no evidence of significant changes in average quality. This suggest that endogeneity may be a problem for the variable N rather than q The Law School Admission Test (LSAT) is a half-day standardized test required for admission to all 22

24 LSAT scores percentiles in each law school, where weights are the number of students matriculated in each law school. The average state law school ranking is also used as an instrument. It is computed as the weighted average of the 2001 USNews ranking of law schools, where weights are again the number of law school students matriculated. Both measures of quality are expected to be positively correlated with bar exam candidate quality. The number of law school degrees and the number of bachelor degrees (by state and year) are also used as instruments. The former is a measure of law school output and it is expected to be positively correlated with the number of law school candidates. The latter is a measure of the diffusion of secondary level education in the state. States with more educated population are expected to have better candidates. Table V reports the first stage regression results. 6.3 Testing Public Interest Theory and Capture Theory Table VI reports summary statistics and Table VII reports OLS estimation results of (11) and (12). The variable of interest, e l, is the number of candidates passing the exam divided by market size. The null hypothesis β 1 =0corresponds to the outcome of public interest theory, the alternative β 1 > 0 corresponds to the outcome of capture theory. Columns 1, 3 and 5 report the results of estimating model (11), that assumes no asymmetric information (a 2 =0). Columns 2, 4 and 6 report the results of estimating model (12), that allows for the effect of asymmetric information (a 2 6=0). From left to right, columns in Table VII make more general assumptions on the outside option salary (w 0,i,t ). In columns 1 and 2, the outside option salary is assumed to be constant across states. In columns 3 and 4, the outside option is assumed to be a linear function of the entry level salary in the business sector (w bus,i,t ). In column 5 and 6, w 0,i,t is assumed to be a quadratic function of the entry level salary in the business sector. Columns 1 and 2 show that there is a significant correlation between the entry salary in law firms and the number of passers divided by the market size. The null hypothesis 202 law schools that are members of the Law School Admission Council (LSAC). It provides a standard measure of acquired reading and verbal reasoning skills. 23