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Thursday, August 14, 2008

Economic Theories of Firm Behavior: Using Positive Theories of Compliance

Positive Theories of Compliance

Positive theories attempt to explain the behavior of the regulated parties (individuals or firms). These theories are related to the study of what is and how the system works. The discussions will be on economic theories of firm behavior that attempt to answer the question of why firms comply with environmental regulations. I will also discuss about Normative Theories of Compliance in my next article. Researchers and Policy Makers should look at both theories when they want to study or make a policy related to Environmental Policy.

Any study of compliance with environmental regulations should start first with a more basic understanding of firm behavior. After all, there would be no need to study enforcement if all firms complied with the law. Since not all firms do comply with the law, it is interesting to start with a more fundamental question - why do firms comply at all? An obvious economic reason for compliance is that firms respond to both positive and negative incentives. If expected penalties are sufficiently high, the threat of being punished for non-compliance should be an adequate reason for compliance.

An early work that is cited by many subsequent crime and punishment papers is that of Becker (1968). He examined the role of penalties and enforcement in dealing with illegal behavior. Becker claimed that an individual decision to act criminally could be analyzed by exactly the same kind of tools used for other individual decisions, i.e. by the use of the utility theory. This theory postulates that a person commits an offense if the expected utility of the offense activities exceeds the utility he could get by using his time and other resources at legal activities. However, some people become “criminals,” not because their benefits and costs differ from that of other persons, but because their benefits and costs differ (Becker 1968).

This approach implies that there is a function relating to the number of offenses by any person to his probability of conviction, to his punishment if convicted, and to other variables, such as the income available to him in legal and other illegal activities, the frequency of nuisance arrests, and his willingness to commit an illegal act.

People choose to obey or violate the law after a rational calculation of the risk pain versus the expected pleasure derived from an act. Legal punishments serve as deterrent because they communicate the pains likely to be suffered as a result of law violation by those who have been punished (specific deterrence) and by others who might be tempted to transgress (general deterrence). In other words, persons refrain from committing crimes in the first place, or refrain from committing crimes again, because they determine that the costs of doing so outweigh any potential gains (Hatcher, Jaffry, Thebaud & Bennet 2000). Enforcement agencies can give an offender ‘harsh punishment’ in order to set an example to other people. Fear of punishment is in turn typically conceptualized as a function of both the certainty of detection and severity of punishment if detected.

In a standard cost-benefit framework, Lear (1998) shows that an enforcement program will change the benefits of non-compliance by imposing severe penalty on their non-compliance activity. Consider a risk-neutral firm’s decision of whether or not to comply with a costly environmental regulation. Compliance is assumed to reduce firm profits below the level achieved under non-compliance, giving the firm an incentive to violate. In other words, when enforcement agency devotes some resources to monitor non-compliance activities, there are some possibilities that the violators can be detected. However, if enforcement agency does not devote any resources, there is no possibility at all that the violators can be detected. An increase in resources devoted to monitoring and enforcement raises the probability of detection for any given firm and there are diminishing returns to regulatory spending. Monitoring is assumed to be error free: the probability of mistakenly fining a compliant firm is zero.

The Firm will violate the regulation if the expected gain from non-compliance exceeds the expected penalty. For firm which thinks that their expected gain from non-compliance equal to their expected penalty, they will mixes between complying and violating. Lastly, the firm will comply if the expected gain from non-compliance less than the expected penalty.

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