Optimal Inspection under Moral Hazard and Limited Liability of Polluter

We have considered an environmental pollution that seldom occurs but catastrophically destroys the environment once it occurs. While this kind of pollution might be avoided to some extent through precaution activity, the effort to prevent pollution could not be observed by the government without inspection. In addition, the polluter might not afford to compensate for the damage. The first best has not been achieved in the literature when moral hazard and limited liability are considered at the same time. By generalizing other policies including strict liability and negligence rule, we derive an optimal inspection policy under moral hazard and limited liability. The optimal policy is composed of advance payment and ex-post payment after inspection. In other words, we can consider the optimal policy as a deposit/refund system. The first best will always be achieved under the optimal policy as long as the liability covers the first-best effort if inspection cost is negligible. We also derive the second-best policy by taking account of inspection cost.