When a Number Changes the Rules

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A contractor may look at a renovation budget and see a cost estimate.

A floodplain manager may look at the same number and see a switch.

Under the National Flood Insurance Program, communities regulate what FEMA calls a substantial improvement to a building in a Special Flood Hazard Area. At the federal minimum, an improvement becomes substantial when its cost reaches 50 percent of the building’s market value before the work begins. Land is not part of that calculation. Local rules can be stricter.

That can make two nearly identical renovation budgets produce very different projects.

Suppose a building is worth $100,000.

A $49,000 renovation and a $51,000 renovation are only $2,000 apart as construction projects.

Under the federal floodplain threshold, however, they can fall on opposite sides of a regulatory boundary. Once the work qualifies as a substantial improvement, the existing building may have to comply with floodplain requirements that apply to new buildings.

The budget did not merely get larger.

The rules changed.

That is the part of the example worth carrying beyond floodplain management.

Governments frequently regulate things that exist on a continuum: building investment, company size, income, emissions, asset values.

But regulation has to be administered.

An inspector, agency, company, or court needs to be able to determine whether a requirement applies. One way to make that possible is to draw a line:

Below this point, one set of rules applies.

At or above it, another set applies.

The boundary may be perfectly sensible as an administrative tool. In the floodplain case, the purpose is straightforward: if someone is making a major new investment in a flood-prone building, that investment can become the point when the building must meet current flood-resistance requirements rather than indefinitely remaining under older standards.

But once a threshold exists, it becomes part of the decision people are making.

Economists sometimes call an abrupt change in consequences at a threshold a notch.

And people respond to notches.

Researchers studying regulations for public companies, for example, have found firms clustering around public-float thresholds that trigger additional disclosure and governance requirements. The dollar value of a company changes continuously, but the regulatory burden does not. Crossing the boundary changes the calculation.

The same thing can happen with a renovation.

Someone planning the project may reduce its scope, postpone part of the work, increase the project enough to justify the required upgrades, or decide the investment no longer makes sense at all.

Some communities even track improvements cumulatively or use thresholds below FEMA’s 50-percent minimum, specifically because treating each permit independently can otherwise create ways to stay below the line through a series of smaller projects.

This creates a different habit of thought.

Most of us naturally optimize continuous quantities.

How much will this cost?

How much more value will another $10,000 buy?

How many employees can we afford?

People who regularly work with regulation learn to ask another question first:

Where are the boundaries?

Because the difference between $49,000 and $51,000 may not really be $2,000.

One number may describe a larger version of the same project.

The other may describe a different regulatory state entirely.

Sources and further reading

FEMA, Substantial Improvement/Substantial Damage Desk Reference

FEMA, Floodplain Management Requirements: A Study Guide and Desk Reference

Ewens, Xiao, and Xu, Regulatory Costs of Being Public: Evidence from Bunching Estimation