Pigou, Becker and the Regulation of Punishment‐proof Firms

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. If fines are low, then Pigouvian rules for taxing externalities apply, modified to account for costly inspections. According to Becker’s classic work on crime and punishment, however, these inspection costs can be minimized by raising the fines to very high levels. But by bankrupting firms, high fines are shown to increase the external costs generated by a non-compliant firm’s production activities, although they reduce the number of firms that fail to comply with the regulation. We analyze this tradeoff in detail, and obtain some unexpected results about how it should be resolved.