Extended Liability, Costly Monitoring and the Weighted Nash Bargaining Solution
by
Dieter Balkenborg
University of Exeter
Coauthors: Alistair Ulph (University of Southampton)

A wealth-constrained firm running an environmentally risky business may have an insufficient incentive to prevent accidents because it cannot be made fully responsible for damage costs. If the liability for environmental damages is extended to lenders to such firms this may eliminate the inefficiency due to moral hazard provided the lenders can observe the effort to prevent accidents. If this effort cannot be observed the impact of extended liability on accident prevention is ambiguous and depends on how the profits are shared between a firm and its lender. Balkenborg (1998) analysed the effects of extended liability assuming that lender and firm distribute the returns according to a weighted Nash bargaining solution. This analysis is enriched here by the possibility that a lender has costly means to monitor effort. It is shown that the weighted bargaining solution does not have to be monotonic in the costs of monitoring, in particular when the lender has a high bargaining power. On the one hand, a decrease in the costs of monitoring increases the set of feasible contracts between the lender and the firm. On the other hand it makes it attractive to the lender to reduce the rent the firm receives because its effort is not fully observable and to monitor more instead. As a result, lower monitoring costs may lead to lower profits to the firm. Because of this effect, there may be socially too much monitoring and extended liability may reduce social welfare. This may happen even if extended liability would increase social welfare if monitoring costs were either zero or infinite (i.e. monitoring would not be possible). Overall, the case of positive monitoring costs differs drastically from the cases where monitoring is either costless or impossible.

Date received: June 29, 2000

Copyright © 2000 by the author(s). The author(s) of this document and the organizers of the conference have granted their consent to include this abstract in Atlas Conferences Inc. Document # cafl-07.