9. The theory of penalties: ‘leverage’ and ‘dealing’ Winston Harrington and Anthony Heyes INTRODUCTION It risks banality to say that penalty – actual or threatened, real or perceived – is fundamental to the effective operation of any enforcement regime. This is true regardless of the policy instrument adopted, and whether enforcement occurs through the channels of administrative, criminal or civil law. The aim here is to outline the simplest economic theory linking penalty levels (and structures) to population compliance rates, and then to consider how that theory has been extended in recent years to take account of the fact that enforcement agencies and regulated firms will typically interact both repeatedly and in a variety of different contexts. The basic economic theory linking penalty and compliance incentives predicts, simply, that a penalty will induce compliance (under standard assumptions) if the expected value of the penalty exceeds the cost of complying and hence avoiding that penalty. Consider, first, a firm facing a ‘binary’ – or ‘yes/no’ – compliance problem. Such problems may arise in some real situations, such as where a polluting firm is required to install a particular piece of safety equipment and either does or doesn’t, though such specification can more generally be thought of as a modelling convenience (and one very commonly used). If violation is detected with probability p and the penalty for such violation is F then a firm will maximize profit by choosing to comply if and only if: pF > c where c is the firm’s cost of compliance. If...
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