Assume a polluting firm is risk averse and sufficiently wealthy such that bankruptcy is not an issue (i.e. y−a*−D>>0). 

(a) Show by examples that under strict liability a polluter may choose too small or too large a level of care, depending on the curvature properties of the utility and probability functions (use p(a)= min {1/a, 1} and p(a)= 1+ a(a-2)).  

(b) Show that under the negligence rule with a due care level ā:

(i) a polluter will choose the due care level if that level is smaller than the cutoff level â, implicitly defined by

and will act negligently otherwise 

(ii) if a*≤â, the optimal due care level is determined by ā=a*
(iii) if a*>â, the regulator maximizes welfare by choosing a second-best optimal due care level ā=â.

Transcribed Image Text:

p(a' (y))U(ya (y)D)+ [1 p(a;' (y))]U (ya;(y))=U(y),