Environmental regulations are effective when they are accompanied by prescribed penalties and when those penalties are enforced in the case of violation. However, because authorities have to conduct ex-post inspection to verify if polluting firms comply with or violate the regulations, which is costly, they are often reluctant to monitor firms. Thus, it has been an important task for both researchers and politicians to design an effective enforcement mechanism for environmental regulations. A number of theoretical studies tackled this issue. Important topics are (i) optimal levels of monitoring and punishment, (ii) possibility of enforcement of inspection, (iii) asymmetric information on monitoring and compliance costs, (iv) objective functions of authorities, (v) relationships between firms and authorities in terms of dynamic aspects, for example.

This study extends the literature on the second and fourth topics. It is known that when the objective of the authority is welfare maximization or minimization of environmental and inspection costs, the authority does not inspect firms’ behavior and firms do not comply with a regulation in Nash equilibrium (for example, Franckx, 2002, JEEM). Considering the inspection agency whose objective function is the revenue from punishment minus environmental and inspection costs, this study theoretically examines under which conditions inspection is efficiently enforced. In addition, the sharing of inspection cost between the authority and firms are taken into consideration.

The main results are as follows. Similar to the results of the literature, there exists a mixed strategy equilibrium when the revenue from punishment is larger than the inspection cost borne by the agency. The probability of inspection depends on environmental cost and the sharing rule of inspection cost. In addition, the inspection may be enforced either excessively or insufficiently in terms of welfare, which also depends on the sharing rule of inspection cost. In such a case, a sharing rule linked to environmental technology represented by compliance cost or emission levels may improve welfare. Moreover, the case in which there is asymmetric information on environmental technology of polluting firms is analyzed. Uncertainty on the environmental condition that may be influenced by nature/climate is also considered. Our results suggest that, in addition to the mechanisms pointed out in the literature, the objective of authorities in terms of environmental protection and sharing rules of inspection costs between polluting firms and authorities linked to environmental and compliance costs should be carefully considered for enforcing environmental regulations efficiently.