Guilty until Proven Innocent-Regulation with Costly and Limited Enforcement

Abstract

We consider optimal regulations for a polluting firm when regulators cannot observe emission control costs and can only observe emissions via costly monitoring. Fines (or subsidies) for enforcing compliance are also limited. The optimal regulations resemble a deposit-refund system. The firm reports its emissions and pays an initial tax based on this report. If the firm is monitored, it receives a rebate when actual and reported emissions coincide. The enforcement constraints and the firm's rights determine whether the incentives to reduce emissions are optimally provided by varying the rebate for compliance, the monitoring probability, or the initial tax.