Learning about compliance under asymmetric information*

Over time, inspection agencies gather information about firms that cause harmful externalities. This information may allow agencies to differentiate their monitoring strategies in the future, since inspections can be influenced by firms ’ past performance relative to other competitors in the market. If a firm is less successful than its peers in reducing the externality, it faces the risk of being targeted for increased inspections in the next period. This risk of stricter monitoring might induce high-cost firms to mimic low-cost firms, while the latter might try to avoid being mimicked. We show that under certain circumstances, the ongoing signaling game between firm types might reduce socially harmful activities