On the optimal use of ex ante regulation and ex post liability

We build on Shavellʹs [J. Econ. 15 (1984) 271] analysis of the optimal use of ex ante and ex post interventions when a firm engages into activities potentially risky for the environment or third parties and has private information about the level of the damage. The regulator enforces ex ante a standard of precautionary effort but is uninformed about the harm level; ex post, in the event of an accident, the judge may bring a lawsuit and discover the harm level. The social optimum can be reached if, ex ante, the regulator offers the firm a menu of incentive contracts (rewards, penalties and verifiable standards). When the precautionary effort is no longer verifiable, the inefficiencies generated by the moral hazard incentive problem cannot be circumvented.