This study explores how an extended liability scheme affects a judgment-proof firm’s precaution levels to prevent accidents and reduce damage when the regulator cannot observe the firm’s private transactions. For this purpose, we incorporate the firm’s precautions to reduce damage into the model proposed by Hiriart and Martimort [1], who only investigated accident prevention. Then, we examine the optimal regulation of a firm that takes measures to reduce not only the probability of a serious environmental accident but also the extent of the damage of such an accident and analyze how the levels of these two types of efforts are affected by introducing an extended liability scheme. We expand the results of Hiriart and Martimort [1] by showing that extending liability to the firm’s stakeholders may improve social welfare by enhancing accident prevention efforts and by weakening damage reduction efforts even when the regulator cannot observe the private transactions between the firm and its stakeholders.
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