Environmental Risk Regulation and Liability under Adverse Selection and Moral Hazard

This paper analyzes the impact of risk regulation and extended liability on private contracting when production creates an environmental risk on third-parties. We start by deriving the optimal regulation of a buyer-seller (principal-agent) relationship under adverse selection on the seller’s production costs, moral hazard on his safety care and limited liability. This optimal regulation must trade off allocative efficiency against rent extraction in a framework where the firm is rewarded only with moral hazard rent. As a result, the optimal regulation induces some form of complementarity between care and output, even in the absence of any technological interaction. Output distortions are stronger when there is no limit on liability. This optimal regulation can sometimes be implemented with a simple ex post liability rule, provided that the buyer has enough wealth. When liability is extended towards a shallow-pocket buyer, the optimal contract between the buyer and the seller must also avoid any accident to secure gains from trade. Optimal contracts in the extended liability regime are quite comparable with those in the optimal regulation and still exhibit a complementarity between outputs and levels of care even though output distortions are now severe. JEL Classification Nos.: L51, K32, D82.