Abstract:We characterize the optimal regulation of a firm which undertakes an environmentally risky activity. This firm (the agent) is protected by limited liability and bound by contract to a stakeholder (the principal). A key feature is the non-observability of the level of safety care exerted by the agent. This level of care depends both on the degree of incompleteness of the regulatory contract (i.e., whether private transactions can be controlled or not) and on the allocation of bargaining power between the principal and the agent. Increasing the wealth of the principal that can be seized upon an accident has no value when private transactions are regulated but might strictly improve welfare otherwise. We derive bounds on the principal's wealth so that the second-best complete regulatory outcome can still be achieved with an incomplete regulation if it is supplemented by an ex post extended liability regime. Extensions to the cases of multiple principals and of a ban on regulatory rewards are also analyzed. * Financial support by the French Ministry of Ecology and Sustainable Development is acknowledged. We are indebted to the editor Joseph Harrington and to two referees for useful comments which have much improved the presentation of the paper. We also thank for comments Denis Gromb and audiences at various seminars and conferences.

We analyze the regulation of firms that undertake socially risky activities but can reduce the probability of an accident inflicted on third parties by carrying out non verifiable effort. Congress delegates regulation to an agency, although these two bodies may have different preferences toward the industry. The optimal level of discretion left to the agency results from the following trade‐off: the agency can tailor discretionary policies to its expert knowledge about potential harm, but it implements policies that are too “pro‐industry.” The agency should be given full discretion when the firm is solvent; partial discretion is preferred otherwise. We then investigate how this trade‐off changes as the political and economic landscapes are modified.

We compare the performance of liability rules for managing environmental disasters when third parties are harmed and cannot always be compensated. A firm can invest in safety to reduce the likelihood of accidents. The firm's investment is unobservable to authorities. Externality and asymmetric information call for public intervention to define rules aimed at increasing prevention. We determine the investment in safety under No Liability, Strict Liability and Negligence, and compare it to the first best. Additionally, we investigate how the (dis)ability of the firm to fully cover potential damages affects the firm's behavior. An experiment tests the theoretical predictions. In line with theory, Strict Liability and Negligence are equally effective; both perform better than No Liability; investment in safety is not sensitive to the ability of the firm to compensate potential victims. In contrast with theory, prevention rates absent liability are much higher and liability is much less effective than predicted.

SummaryWhen a firm undertakes risky activities, the conflict between social and private incentives to implement safety care requires public intervention which can take the form of both monetary incentives but also ex ante or ex post monitoring, i.e., before or after an accident occurs. We delineate the optimal scope of monitoring depending on whether public monitors are benevolent or corruptible. We show that separating the ex ante and the ex post monitors increases the likelihood of ex post investigation, helps prevent capture and improves welfare. Keywords AbstractWhen a firm undertakes risky activities, the conflict between social and private incentives to implement safety care requires public intervention which can take the form of both monetary incentives but also ex ante or ex post monitoring, i.e., before or after an accident occurs. We delineate the optimal scope of monitoring depending on whether public monitors are benevolent or corruptible. We show that separating the ex ante and the ex post monitors increases the likelihood of ex post investigation, helps prevent capture and improves welfare.