Non-compliance and Avoidance

Imagine an economic agent who does not have an incentive to comply with a given policy. Furthermore, picture a situation where the agent can decrease the probability of being caught for non-compliance by engaging in avoidance activities. It is these two thoughts that form the landscape of this study: non-compliance and avoidance.

In order to discuss avoidance and compliance, three principal-agent schemes with an exogenous fine are introduced. Both information asymmetries, hidden action (moral hazard) and hidden knowledge (adverse selection), are considered separately.

In the hidden action setup, the agent has to comply with a given regulation. It turns out that the optimal regulatory policy, which guarantees the agent’s compliance, depends on the strategic relationship of avoidance and monitoring. If monitoring and avoidance are strategic complements, then the principal’s monitoring efforts are compromised, and for this reason, the optimal regulatory policy is lenient. However, if avoidance and monitoring are strategic substitutes, then monitoring is not compromised, and in this situation, the optimal regulatory policy is strict.

In the hidden knowledge setup, the agent is obligated to report his type to the principal. A truthful report is interpreted as compliance, and a misreport non-compliance. Under this discussion, the concept of monitoring is replaced with auditing, and moreover, it is assumed that auditing and avoidance are strategic complements. It turns out that whenever avoidance is cheap and efficient, then, in addition to information rent, it is optimal to give the agent avoidance rent.

Contact Petteri Palonen

Email: petteri.palonen@helsinki.fi