Abstract
We study optimal government policy when firms' operations involve a risk of a large environmental accident, firms do not have sufficient assets to cover such costs, and the risk is affected by firms' efforts which are unobservable to outsiders. When firms' profits and government revenues have equal weights in the social welfare function, a first best can be implemented and requires that the firm be subsidized heavily when operating with no accident, and all its assets confiscated in the event of an accident. With a lower weight on firm profits the solution is always second best, with lower subsidies to the firm, and a firm effort lower than at the first-best solution. When firm investments affect both the required accident-preventing effort for given risk and the work effort required for a given output, the first best never involves specific investment subsidies, while a second-best solution generally always does.
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The paper is part of the research project “Environmental policy under asymmetric information', at the SNF Centre for research in economics and business administration, Department of Economics, University of Oslo. I thank, without implicating, Mikael Hoel, Jean-Charles Rochet, Jean Tirole, and two anonymous referees for helpful comments on a preliminary version.
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Strand, J. Environmental accidents under moral hazard and limited firm liability. Environ Resource Econ 4, 495–509 (1994). https://doi.org/10.1007/BF00691925
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DOI: https://doi.org/10.1007/BF00691925