The time has come to end the stalemate between those who favor stronger regulation of business by government and those who urge deregulation. Good regulatory policy is not about choosing between the free market and government intervention. Nor is it simply about deciding what the law should prohibit. Sound regulatory policy can also grow from an interdependence between private regulation—by industry associations, companies, peers and individual consciences—and government.

In the not-so-distant past, there were two models of regulation: deterrence and compliance. These reflected the varying views of how best to persuade business to operate lawfully, safely and responsibly. Some people believed corporations would comply with the law only when faced with tough sanctions. Others believed gentle persuasion was the best way to secure business compliance. Fortunately, that era of polarization appears to be passing. As my coauthor John Braithwaite and I have written, polarization is being replaced by the realization that regulation—responsive regulation—works best when business and government strike a balance.

Responsive regulation differs from a traditional regulatory environment in that it offers a new view of what should trigger regulatory intervention and what that intervention should be. It calls for regulators to oversee each industry differently, since each has its own structure, objectives and motivations. Regulatory strategy should depend on an industry’s history and culture, and allow for a variety of regulatory approaches. In large part, the attitude and behavior of an industry or company toward its own internal surveillance should determine the regulatory approach and the degree of government intervention.

Playing the Game

Game theory offers some valuable insight into how best to practice responsive regulation, keeping in mind that a strong motivation for many businesses is to minimize regulatory costs, and the typical motivation of a regulator is to maximize compliance outcomes. In such settings, a dynamic enforcement game—tit-for-tat enforcement—is often the best strategy and the most likely to establish mutually beneficial cooperation. Using this strategy, the regulator refrains from a disciplinary response as long as a company cooperates and works in good faith.

However, if a company gives in to the temptation to take advantage of a regulator’s benevolent posture, the regulator shifts from a cooperative to a deterrence stance through an act of retaliation. If, and only if, the company responds to government retaliation by returning to cooperation is the spirit of collaboration restored.

Another way to look at responsive regulation is as an enforcement pyramid (see chart below). Most regulatory action against industry occurs at the broad base of the pyramid, where the regulated industry or business monitors itself and the regulator’s primary involvement is to coax compliance by persuasion. When self-regulation and persuasion don’t work, the regulator moves up to the next level, the warning letter. When letters fail, monetary penalties are imposed. The next step up the pyramid is a plant shutdown, for example, or suspension of a license to operate. At the top of the structure is permanent license revocation.

Consider a plant that requires pollution controls. Every time a regulator has to move up the pyramid for lack of corporate compliance, options for the manufacturer narrow and government involvement increases. For every 10 private inspections conducted internally at the base of the pyramid, perhaps one EPA inspection is required. But reach a point where a company requires 10 EPA inspections for lack of compliance, and the Justice Department is called in.

Regulatory agencies are best able to secure compliance when they act as benign big guns. That is, they’re better equipped to speak softly when they carry big sticks—a hierarchy of increasingly tough penalties.

A good example of how self-regulation can work to a business’ advantage is the New York Stock Exchange (NYSE). A condition of listing on the NYSE is that a corporation must open its books to that governing body. The U.S. Securities and Exchange Commission keeps its distance as a result of the NYSE’s self-monitoring. Why would a listed company cooperate so readily with the NYSE’s powers-that-be? Sometimes it’s less threatening to open the books to fellow businesspeople than to government regulators. If such cooperation brings fewer government audits and reduced threat of penalties, so much the better.

The pyramid assumes companies are interested in maximizing profits, and that in pursuit of those profits they will agree to participate fully on the pyramid’s lower levels. They know more government intervention awaits them higher up.

Public Interest Empowered

Business regulation is typically modeled as a game between two players: the regulatory agency and the company. But it’s more complicated than that. On the regulatory side, there are many players, including prosecutors and legislative oversight committees. On the business side, there are industry groups such as associations. And on both sides, there are individuals who wear multiple hats.

That’s why the involvement of public interest groups—tripartism—is so important to responsive regulation. Responsive regulation provides those groups access to the same information available to regulators, as well as the power to bring enforcement actions. Most industries, of course, would cringe at the idea of offering public interest groups a seat at the table, yet there’s good reason for what many may consider a radical and even distasteful arrangement.

The complaint of industry against public interest group empowerment is that the groups will demand a higher standard than required by law. But in truth, any demands made by public interest groups will be counterbalanced by industry demands for lower standards. The outcome will likely fall closer to the settled upon legal standard.

There’s another important reason to let in public interest groups: When they’re locked out of the process, they are more likely to take a hostile stance, seeking harsher laws and bigger payoffs. But involve them, and they’re apt to participate in cooperative negotiations.

The trick is to steer a course between the practical impossibility of mass participation and the danger of participation by public interest groups with a narrow but powerful leadership base. Those extremes can be avoided by denying power to groups not democratically constituted and empowering groups with rising popular support. Certainly, doing favors for the public interest group with the strongest base of support is good politics.

It’s time to rethink regulation and discard tightly held notions of the past. The intransigence of the opposing camps—one arguing that regulation is inefficient and stifling, the other that it’s ineffectual and co-opted—has brought regulation to an impasse. By delegating certain regulatory tasks to private parties, government can focus on reconciling regulatory goals with laissez-faire notions of market efficiency. And it allows for the prospect of finding a regulatory equilibrium that retains the benefits of competition, while the potential for escalating government intervention maintains the integrity of regulatory goals.

Ian Ayres is the William K. Townsend Professor at Yale Law School and a professor at the Yale School of Management. His latest book is Super Crunchers: Why Thinking-By-Numbers Is The New Way To Be Smart.