Setting Standards for Credible Compliance and Law Enforcement*

CIRANO is a private non-profit organization incorporated under the Québec Companies Act. Its infrastructure and research activities are funded through fees paid by member organizations, an infrastructure grant from the Ministère de l’Industrie, du Commerce, de la Science et de la Technologie, and grants and research mandates obtained by its research teams. The Scientific Series fulfils one of the missions of CIRANO: to develop the scientific analysis of organizations and strategic behaviour. This paper examines the setting of optimal legal standards to simultaneously induce parties to invest in care and to motivate law enforcers to detect violators of the law. The strategic interaction between care providers and law enforcers determines the degree of efficiency achieved by the standards. Our principal finding is that some divergence between the marginal benefits and marginal costs of providing care is required to control enforcement costs. Further, the setting of standards may effectively substitute for the setting of fines when penalties for violation are fixed. In particular, maximal fines may be welfare reducing when standards are set optimally. Most recently displeasure with the performance of the Internal Revenue's Service 1 prompted Congress to cut the agency's compliance budget. Previous to this Congress had similarly intervened in the affairs of the FTC and the EPA to correct what it perceived as inappropriate enforcement of government policy. This approach differs significantly from most of the formal literature on law 2 enforcement and monitoring, as exemplified by Baron and Besanko (1984), Border and Sobel (1987) and Mookherjee and P'ng (1992, 1994), These analyses assume that law enforcers can commit to a monitoring strategy independent of whether the strategy uncovers violators in equilibrium. A notable exception is Graetz et al (1986) who assume that enforcers are motivated by the fines they collect from prosecuting violators.