On the Limitation of Penalties and the Non-Equivalence of Penalties and Taxes

This paper compares the impacts of a penalty on accident and a per-unit tax on output, when social damages depend on the output of firms. The choice of the optimal regulation, aiming at internalizing a damage, is influenced both by the market power of firms and by their potential (in)solvency in case of accident. Output strategies influence the solvency situation of firms for paying a penalty, which may lead to multiple equilibria (all firms are either solvent or insolvent in case of accident). When social damages are large, the optimal penalty is capped for avoiding a situation with insolvent firms. In this case, a regulator implements a per-unit tax.