Question

Suppose you were asked to comment on a proposed policy to control oil spills. Since the average cost of an oil spill has been computed as $X, the proposed policy would require any firm responsible for a spill immediately to pay the government $X. Is this likely to result in the efficient amount of precaution against oil spills? Why or why not?

Answer 1

We have to see efficiency in terms of social optimum rather than free market optimal levels. This is because oil spills entail externalities to society which may cause greater damage than a sum of money penalized for lack of negligency and precautions.

Further in the absence of any penalty, private owners would take into account all litigation costs associated , oil damage and lost, cost of clean up and other associated private costs only. They will ultimately recover these costs overtime from insurance policy. They would equate only private costs of oil spills with precautionary costs. If former is greater than latter , it would be beneficial for firms to take precautions otherwise they would not take precautions.

Now, whether an upfront penalty amount acts as an adequate deterrent to take precautions will determine efficiency of State policy to control oil spills. This depends on

1. The size of penalty and whether it is upfront lump sum or tied with amount of damage caused. If it is common lump sum amount for all firms, whether big or small, it gives negative signals to take minimal precautions as damage whether big or small would cost same in penalty.

2. Laws and regulations that can assess the level of negligence and incidence of liability.

3. Whether oil spills can be detected and cost of detecting.

4. Insurance policy - there may be a moral hazard problem which causes firms to take sub optimal precautions because costs will be recovered eventually from insurance.

Only an upfront penalty is not a comprehensive deterrent against oil spills. There has to be supplementary measures that without damaging shareholders wealth( oil firms are usually publicly listed so very high upfront penalties can affect firm reputation and share prices), reduce environmental threats and signal firms to take adequate precautions.