Moral Hazard, Compliance and Avoidance

This thesis considers a situation in which an economic agent has an incentive to not comply with the given regulation. Furthermore, the agent has an ability to allocate his resources in such a way that it decreases the probability of being caught for non-compliance. The economic literature on optimal enforcement uses the word 'avoidance' to refer to an activity which decreases the individual’s probability of being caught. The aim of this thesis is to analyze the optimal strategy to eradicate non-compliance when avoidance is present. A simple principal-agent scheme is introduced in order to discuss the optimal strategy to ensure the agent's compliance. Although this thesis contributes to the discussion of enforcement, the focus is not on fines. For the most part, the fine is assumed to be fixed. The analysis presented here has its interest in the optimal amount of socially harmful behavior and monitoring. The results suggest that, whenever asymmetric information and avoidance prevail, the optimal strategy to eradicate non-compliance depends on the agent's response on monitoring. If the agent's response to an increase in monitoring is to decrease his expenditure on avoidance, then the optimal restriction of the agent's harmful behavior is strict. However, if the agent's response to an increase in monitoring is to increase his expenditure avoidance, then monitoring is inefficient and it leads to an increase of potential resource waste, and for these reasons, it is optimal to relax the restricted amount of harmful behavior. The conclusion is that, whenever there is a valid reason to assume that the agent is willing to increase his expenditure on avoidance as a response to monitoring, regulators might be better off with a somewhat more lenient restriction on the amount of harmful behavior instead of a strict one