The Impact of Court Errors on Liability Sharing and Safety Regulation for Environmental/Industrial Accidents

We focus in this paper on the effects of court errors on the optimal sharing of liability between firms and financiers, as an environmental policy instrument. Using a structural model of the interactions between firms, financial institutions, governments and courts we show, through numerical simulations, the distortions in liability sharing between firms and financiers that the imperfect implementation of government policies implies. We consider in particular the role played by the efficiency of the courts in jointly avoiding Type I (finding an innocent firm guilty of inappropriate care) and Type II (finding a guilty firm not guilty of inappropriate care) errors. This role is considered in a context where liability sharing is already distorted (when compared with first best values) due not only to the courts’ own imperfect assessment of safety care levels exerted by firms but also to the presence of moral hazard and adverse selection in financial contracting. There is also not congruence of objectives between firms and financiers on the one hand and social welfare maximization on the other. Our results indicate that an increase in the efficiency of court system in avoiding errors raises safety care level, thereby reducing the probability of accident, and allowing the social welfare maximizing government to impose a lower liability [higher] share for firms [financiers] as well as a lower standard level of care