Pollution , Financial Crises , and Minor

We study the use of fines and inspections to control production activities that create external damages. The model contains a continuum of firms, differing in their compliance costs, so that only high-cost firms evade the regulations. Modifying the usual Pigou rule for taxing externalities to account for costly inspections, the external damage from the marginal evader’s activities should exceed the expected fine by an amount equal to the resources expended to reduce the number of evaders a unit. According to Becker’s classic work on crime and punishment, however, these resources can be minimized by raising the fines to very high levels, while reducing costly inspections. We argue that the modified Pigou rule does not hold under such a policy, because it distorts capital markets. Firms caught evading the regulation will be bankrupted by the fines, and the possibility that they will not fully repay investors lowers their expected cost of capital. Investors will lend to all firms at an interest rate above the social opportunity cost of capital, to compensate for the risks of bankruptcy. The paper investigates the optimal choice between the Becker approach of high fines and few inspections, versus keeping fines low enough to eliminate capital-market distortions, in which case the modified Pigou rule holds. We derive conditions that determine how this choice should be resolved. In some case, welfare can be improved over the Pigou optimum with an equilibrium under which some regulation-evading firms risk bankruptcy, whereas others choose capital stocks low enough to eliminate such risks.