Competing to Discover Compliance Violations: Self-Inspections and Enforcement Policies

To enable cost-effective enforcement of environmental compliance standards, regulatory agencies encourage production firms to voluntarily discover and correct compliance violations. Although such self-regulation activities often bring desired benefits, they create nontrivial challenges. To study this tradeoff, we develop a model that captures the interactions between a regulator and a firm that unfold over time. Because constant monitoring is prohibitive, the regulator and the firm perform costly inspections to discover the compliance state of production. If the regulator detects noncompliance, the firm is required to pay penalty and restore compliance. To avoid penalty, the firm performs self-inspections to preemptively detect noncompliance and restore compliance without reporting the action to the regulator. We show that inefficiency caused by the firm’s private action is amplified if the regulator adopts a policy of requiring permanent restoration. Under such a policy, the firm’s self-inspections may leave the regulator and the environment worse off. By contrast, self-inspections always bring a net benefit to the regulator if repeated temporary restorations are allowed. We also find that, due to self-inspections, a paradoxical situation arises where the regulator prefers mandating permanent restoration despite having a small chance of enforcing it.