Working Paper No. 07-37:
Avoidance Costs in Optimal Penalties
Date Posted: 2007
This paper develops the point that avoiding a legal prohibition is not free, but rather involves "avoidance costs" that must be considered in determining an optimal public law enforcement policy. While obvious in an organizational context, the point is completely general. In the case of individuals, there are more subtle types of avoidance costs in the form of lost opportunities for productive activity, which are difficult to observe directly but may have a very significant aggregate effect on social welfare. Therefore, the significance of avoidance costs extends to all types of potential offenders and offenses. The existing literature does not explicitly consider the problem of avoidance costs in determining optimal enforcement, and in some instances offers solutions that depend critically on the implicit assumption that avoidance costs are zero. If avoidance costs are considered, the optimal enforcement policy is affected in certain circumstances. In particular, the policy of setting expected penalties equal to the violator's gain, in order to reduce public enforcement costs, is shown to be sub-optimal even where it can be assumed that violators' gains are always less than the external harm created by the violation. More generally, the existence of avoidance costs and their dependence on the expected penalty level explains why optimal penalties always should be based on external harm, and never on the violator's gain.