REGULATORY ERRORS, OPTIMAL FINES AND THE LEVEL OF COMPLIANCE

This paper shows that with a hierarchical structure of enforcement, regulatory errors cause the optimal penalty to be non-maximal even if offenders are risk neutral (and fines are pure transfers), and the private benefit from violation is strictly less than the social cost for all individuals. In contrast, with error-free monitoring, no finite fine is optimal within the same hierarchical structure. Also, full compliance is an equilibrium outcome in the presence of errors whereas, in the absence of errors, the regulator can achieve only partial compliance.