Concealment and verification over environmental regulations: a game-theoretic analysis

We consider a strategic situation in which a firm may conceal the illegal activity of violating environmental regulations and a regulator seeks to verify the illegality to punish the firm. We study two main factors, fines and social monitoring, that influence the firm’s decision in that situation. First, we find all the possible equilibria of our model and examine conditions of those two factors that lead to each equilibrium. Using the equilibrium conditions, we then study the optimal enforcement policies that induce the most socially desirable equilibrium and improve social welfare within each equilibrium. Our main findings are as follows. First, the two factors have a complementary relationship in getting the most desirable equilibrium: Certain high levels of fines and social monitoring are both needed. Second, if making the social monitoring above the certain critical level is impossible, setting the level of the fines as high as possible may be the optimal enforcement policy. Finally, if setting the fines above the certain critical level is not available, either, setting the level of the fines as low as possible might be optimal, and the higher level of the social monitoring does not necessarily bring higher social welfare.