Optimal Enforcement Strategy to Prevent Oil Spills: An Application of a Principal-Agent Model with Moral Hazard

Abstract

THE purpose of this paper is to provide a general framework from which to analyze government monitoring and enforcement of regulations designed to reduce stochastic externalities. Examples of stochastic externalities include many types of pollution, such as nuclear power plant accidents, oil spills, and leakages from hazardous-waste dumps. Many other health and safety issues may be thought of in this manner, such as the regulation of the workplace by the Occupational Safety and Health Administration (OSHA) and the regulation of prescription drugs and food additives by the Food and Drug Administration (FDA). A final example may be the auto defects program of the Federal Trade Commission (FTC), which is designed to redress consumers for systematic defects that occur after a manufacturer's warranty period has expired. The problem of externalities and their theoretical solutions has received considerable attention in the economics literature. We know, for example, that pollution should be controlled so as to equate marginal costs with marginal benefits. Implementing this rather simple rule, however, is not a straightforward exercise. The effectiveness of any regulation will