Professor, Faculty of Economics, Kansai University
Visiting Professor, Graduate School of Economics and Management, Tohoku University

Professor/Director, Research Center for Policy Design
Graduate School of Economics and Management, Tohoku University

Associate Professor, Faculty of Economics, Kyusyu Sangyo University
Visiting Associate Professor, Graduate School of Economics and Management, Tohoku University

We have considered an environmental pollution that catastrophically destroys the environment once it occurs. While this kind of pollution could be avoided to some extent through precautionary activity, efforts to prevent pollution could not be observed by a government without inspection. In addition, the polluter might not be able to afford to compensate for the damage. The first best has not been achieved in the literature when moral hazard and limited liability are considered at the same time. By generalizing other policies, including the strict liability rule and the negligence rule, we derive an optimal inspection policy under moral hazard and limited liability. The optimal policy is composed of advance payment and ex-post payment after inspection. In other words, we can consider the optimal policy as a deposit/refund system. We derive the second-best policy by taking account of inspection cost.