Moral Hazard, Risk Aversion and Compliance Monitoring in Agri-Environmental Policy

Agri-environmental policy is modelled as a social welfare maximisation problem that recognises the potential trade-off between increased environmental benefit and increased cost of monitoring compliance. Moral hazard arises because monitoring does not detect all those who fail to comply with contractual obligations. It is shown that if monitoring costs are negligible of fixed, or farmers are highly risk averse, the moral hazard problem can be eliminated. However, if monitoring costs depend on monitoring effort and the degree of risk aversion is low, only a second-best solution can be obtained. Numerical simulations suggest that optimal monitoring effort declines with increasing farmer risk aversion