General Deterrence, Audit Uncertainty and Environmental Regulation

The efficacy of many government regulations, especially environmental policies, depends largely on the voluntary compliance of subjects. Monitoring of subjects and enforcement of the law acts to induce compliance; however, it is often too costly to employ subjects. Monitoring of subjects and enforcement of the law acts to induce compliance; however, it is often too costly to employ the resources required to induce perfect compliance. Therefore, it is necessary for enforcement agencies to optimize their audit strategy in such a way that maximizes compliance for a given enforcement budget minimizes monitoring costs while simultaneously inducing perfect compliance. A number of studies show that the probability of audit and the size of the penalty for violation impact compliance rates (Andreoni et al, 1998). Not only do these deterrence mechanisms effectively induce compliance in targeted subjects, but in non-targeted subjects as well, which is known as general deterrence. Gray and Shadbegian (2007), focusing on U.S. manufacturers with regulated air pollution, showed an audit of one plant increased compliance at plants located within the same state. Additionally audit uncertainty may have the reverse effect on deterrence: the possibility of finding those in compliance to be in non-compliance (type I error) or those in non-compliance to be in compliance (type II error) results in a reduction in compliance (Rizzoli and Stance 2012). Advancing our understanding of these issues will lead to more efficient enforcement in the sense that for a given budget the regulator will be able to induce a higher level of compliance. The second stage of the project will investigate the effects of general deterrence and audit uncertainty in markets. Fundamentally we are interested in emission trading markets (see Newell et al, 2013 and, Fisher-Vanden and Olmstead 2013 that highlight the importance of carbon markets and the issues with implementing markets to control water pollution respectively.) That being said, the results from our study are equally applicable to any market where noncompliance is an issue including financial markets. We expect this work to result in significant contributions both to the literature on compliance (Alm and McKee 1998) as well as the literature on compliance in emission trading markets (Stranlund et al, 2011, Murphy and Stranlund 2007, and Cason and Gangadharan 2006.) Additionally this work is also related to the extensive public good literature (c.f. Ledyard 1995) and the literature on inducing groups to generate socially optimal contributions (e.g. Tyran and Feld 2006, and Andreoni and Gee 2012.) Moreover we expect to make policy recommendations with respect to enforcing regulation and the design of markets where non-compliance may be an issue.