To Comply or Not To Comply? Pollution Standard Setting Under Costly Monitoring and Sanctioning

In this paper, we characterize optimal regulatory policies composed of pollution standards, probabilities of inspection and fines for non-compliance, in a context where both monitoring and sanctioning are socially costly, and penalties may include gravity and non-gravity components at the regulator's discretion. The optimal policy entails compliance with the standards as long as a quite intuitive condition is met. Non-compliant policies may include standards even below the pollution levels that minimize the sum of abatement costs and external damages. Interestingly, the appropriate structure of penalties under non-compliance is highly progressive, while the best possible shape of the fines under compliance is linear only if non-gravity sanctions are not allowed.