Policy Incentives for Dangerous (But Necessary) Operations

In industries where firms perform dangerous (but necessary) operations, liability costs - due to potential harm to third parties - can be significant. Firms may therefore find it optimal to exit the market, and this may lead to an inefficiently low number of incumbents. A social planner can discourage exit by offering appropriately designed subsidies. Ex ante subsidies defray the costs associated with making operations safer (e.g. funds to subsidize the purchase of safety equipment). Ex post subsidies mitigate the financial damages caused by an accident (e.g. funds to defray the cost of cleaning up a toxic spill). We consider a model where (i) firms have private information about their ability to improve reliability and (ii) reliability investments are unobservable. Our results challenge the view that, in the presence of moral hazard, ex post subsidies are always inferior to ex ante subsidies. We demonstrate that when the social value of reliability outweighs the benefit of increased competition, it is optimal to offer ex ante subsidies alone (i.e. to subsidize the cost of making operations safer). Conversely, when the benefits of competition outweigh the benefits of reliability, a combination of ex ante and ex post subsidies is optimal (i.e. not only to subsidize safer operations, but also to share the costs of a potential accident)