Optimal Risk Regulation of Monopolists with Subjective Risk Assessment

Abstract

This study aims at characterizing the optimal regulation of risky activities when risk assessment is subjective as a result of ambiguity on the probability of an accident. The attitudes toward ambiguity held by stakeholders form subjective risk perceptions, which substantially affect the optimal intervention. To explore this issue, we construct a moral hazard model with the limited-liability constraint, where ambiguity is described by using the Choquet expected utility with a neo-additive capacity. We first show that the monopolist's optimism reduces the equilibrium preventive effort level and increases the optimal fine level, which is in contrast to the effect of less risk-aversion. We then extend the analysis to the case where the regulator can set a product price as another regulatory instrument. The optimal product price is increasing in the monopolist's degree of optimism. Furthermore, under such an optimal scheme, more optimism held by the monopolist does not necessarily reduce the level of preventive effort.

Keywords: Monopoly Regulation, Environmental Risk, Ambiguity, Risk Assessment, Moral Hazard

JEL Classification: L51, D81, D82, Q58