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The effectiveness of environmental regulation is limited by the extent to which those regulations are enforced. Profit-maximizing firms will comply with a regulation if the expected net benefits of compliance are greater than the expected net benefits of noncompliance given the limited enforcement capabilities regulators have at their disposal. Analyses in the literature usually assume that firms know their regulatory status, specifically, whether specific regulatory provisions apply to them or even whether they are subject to regulation at all. But uncertainty about regulatory status is not uncommon. This paper conducts a theoretical and empirical analysis of firms’ compliance strategy when they face uncertainty about their regulatory status. Our theoretical analysis indicates that the optimal strategy for a firm with a sufficiently low probability of being subject to enforcement action will be to delay developing a protocol until warned and then delay implementation until being inspected and warned. We analyze the effect of this kind of regulatory uncertainty on the compliance protocol development component of regulations empirically within the context of the Maryland Water Quality Improvement Act (WQIA) of 1998, which requires farms meeting certain criteria to develop, file, and implement a nutrient management plan. The Maryland Department of Agriculture (MDA), which enforces this regulation, has a registry of farms that includes less than half of the farm operations in Maryland. We conduct an econometric analysis using farm level data from a University of Maryland survey combined with county-level enforcement data from MDA. Our econometric model indicates that the probability of being included in the MDA farm registry is associated with a statistically significant and economically meaningful increase in the probability of being in compliance with nutrient management regulations. Further, the probability of being in compliance is increasing in farm size while the marginal effect of being included in the MDA farm registry is decreasing in farm size; both results are consistent with the predictions of our theoretical model.

Regulated Firm Strategy under Uncertainty about Regulatory Status