Costly (Dis)Agreement: Optimal Intervention, Income Redistribution, and Transfer Efficiency of Output Quotas in the Presence of Cheating

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1 University of Nebraska - Linoln DigitalCoons@University of Nebraska - Linoln Faulty Publiations: Agriultural Eonois Agriultural Eonois Departent April 23 Costly (Dis)Agreeent: Optial Intervention, Inoe Redistribution, and Transfer Effiieny of Output Quotas in the Presene of Cheating Konstantinos Giannakas Departent of Agriultural Eonois, University of Nebraska-Linoln, Linoln, Nebraska, USA, kgiannakas2@unl.edu Murray Fulton University of Saskathewan, Saskatoon, SK, Canada Follow this and additional works at: Part of the Agriultural and Resoure Eonois Coons Giannakas, Konstantinos and Fulton, Murray, "Costly (Dis)Agreeent: Optial Intervention, Inoe Redistribution, and Transfer Effiieny of Output Quotas in the Presene of Cheating" (23). Faulty Publiations: Agriultural Eonois This Artile is brought to you for free and open aess by the Agriultural Eonois Departent at DigitalCoons@University of Nebraska - Linoln. It has been aepted for inlusion in Faulty Publiations: Agriultural Eonois by an authorized adinistrator of DigitalCoons@University of Nebraska - Linoln.

2 Journal of Agriultural & Food Industrial Organization Volue 1 23 Artile 11 Costly (Dis)Agreeent: Optial Intervention, Inoe Redistribution, and Transfer Effiieny of Output Quotas in the Presene of Cheating Konstantinos Giannakas Murray Fulton Departent of Agriultural Eonois, University of Nebraska-Linoln, Linoln, Nebraska, USA, kgiannakas2@unl.edu Departent of Agriultural Eonois, University of Saskathewan, Saskatoon, SK, Canada, Copyright 23 by the authors. All rights reserved. No part of this publiation ay be reprodued, stored in a retrieval syste, or transitted, in any for or by any eans, eletroni, ehanial, photoopying, reording, or otherwise, without the prior written perission of the publisher, bepress, whih has been given ertain exlusive rights by the author. Journal of Agriultural & Food Industrial Organization is produed by The Berkeley Eletroni Press (bepress).

3 Costly (Dis)Agreeent: Optial Intervention, Inoe Redistribution, and Transfer Effiieny of Output Quotas in the Presene of Cheating Konstantinos Giannakas and Murray Fulton Abstrat This study builds on previous work by Giannakas and Fulton (23, 2) on the eonois of output quotas in the presene of heating by exaining the effiieny of the poliy in transferring inoe to produers as well as the optial regulatory response to enforeent osts and farer nonopliant behavior in a deentralized poliy aking environent. Analytial results show that enforeent osts and heating hange the transfer effiieny of output quotas, the level of intervention that transfers a given surplus to produers, the soially optial inoe redistribution, and the soial welfare fro intervention. The inidene of the poliy is shown to depend on the relative politial preferenes of the poliy akers and the poliy enforers aking the onsideration of the deentralized poliy aking struture ritial in analyzing output quotas in the presene of heating. KEYWORDS: quotas, heating, agriultural poliy, distribution, welfare

4 Giannakas and Fulton: Effiieny of Output Quotas in the Presene of Cheating 1 1. Introdution In a reent artile published in this Journal, Giannakas and Fulton (GF hereafter) exaine the optial enforeent of output quotas in the presene of enforeent osts and farer nonopliane with the provisions of the quota progra. In partiular, GF (23) analyze the optial enforeent of supply restritions in a deentralized poliy aking struture that onsiders separately the deisions of the poliy aker and the poliy enforer. The key (and rather ounter-intuitive) result of their study is that progra enforeent inreases with the weight plaed by the enforeent ageny on produer welfare. This result stes fro their finding that, while violation of the quota liit ight be optial for the individual produer that holds opetitive onjetures, above-quota prodution depresses arket prie and produer welfare. Thus, an enforeent ageny operating with the interests of produers in ind will restrit the very ations these produers would prefer to undertake. In this paper, we extend the work of GF (23) to exaine the effiieny of the poliy in redistributing inoe to produers in the presene of heating as well as the optial regulatory responses to enforeent osts and produer nonopliant behavior. In partiular, we exaine the onsequenes of enforeent osts and heating on the transfer effiieny of output quotas and on the level of the soially optial poliy intervention and inoe redistribution under the different poliy enforeent senarios analyzed in GF (23). The transfer effiieny of output quotas in the presene of heating has also been exained in an earlier artile by GF that introdued enforeent osts and heating into the eonoi analysis of output quotas. In partiular, GF (2) exaine the raifiations of enforeent osts and above-quota prodution for the transfer effiieny of the poliy in a entralized poliy aking environent where poliy design and ipleentation are the responsibility of a single ageny. In analyzing the transfer effiieny of the poliy ehanis and the optial regulatory responses to enforeent iperfetions, this paper adopts the deentralized poliy aking environent introdued in GF (23). This riher poliy aking struture, whih onsiders separately the deisions of the poliy aker and the poliy enforer, is required beause differenes in the politial preferenes of the two groups are shown to signifiantly affet the level of poliy intervention and the inidene of output quotas. 1 Siilar to the previous papers by GF, the eonoi onsequenes of enforeent osts and heating are onsidered in the ontext of a stati, partial equilibriu, losed eonoy odel. Sine this paper builds on the results of GF (23), an understanding of this earlier paper will assist in delving into the present artile. The rest of the paper is organized as follows. The next setion analyzes the effet of enforeent osts and heating on the level of poliy intervention (i.e., the level of output quota) that transfers a given surplus to produers of the regulated oodity. To do this, the next setion looks at the proble of a regulator that desires to ake a speifi inoe transfer to agriultural produers under the different senarios on poliy enforeent (deterined by the enforeent ageny) onsidered in GF (23). The setion following links the surplus transfer to produers with the distortionary osts of arket intervention to deterine the effiieny of the poliy in redistributing inoe in the eonoy under ostly enforeent. One the transfer effiieny of output quotas has been deterined, the paper endogenizes the surplus transfer to produers it onsiders the soially optial inoe redistribution and the soial welfare fro intervention when enforeent is ostly. While ost of the analysis fouses on the ase where penalties for quota violations are exogenous to the ageny responsible for the enforeent of the far progra, for opleteness of exposition, the ipliations of endogenizing penalties are disussed before oving to the onluding setion of the paper. 1 As pointed out in GF (23), by onsidering a entralized poliy aking struture, the analysis of GF (2) ipliitly assues idential politial preferenes of the regulatory and enforeent agenies involved in agriultural poliy aking. Produed by The Berkeley Eletroni Press, 27

5 2 Journal of Agriultural & Food Industrial Organization Vol. 1 [23], Artile Regulator and Optial Intervention Consider first the ase of a regulatory ageny that desires to transfer a given surplus to produers of the regulated oodity. In the deentralized poliy aking environent onsidered in this paper, the regulator oves first and deterines the quota level Q that will ahieve the desired inoe redistribution knowing the reation funtions of both the enforeent ageny and the produers [given by equations (7)-(9) and equation (4) in GF (23)]. In other words, this setion analyzes the first stage of a three-stage gae between the regulator, the enforeent ageny and the farers where the regulator deides on the level of Q that transfers a given surplus to produers knowing exatly how this hoie will affet the levels of enforeent and prodution. The optial hoies of the enforeent ageny and the farers (deterined in the seond and third stage of the gae, respetively) are exained in GF (23) and are known by the regulator. Note that, sine output quotas involve surplus transfers fro onsuers to produers, a neessary ondition for the adoption of the far progra is that the weight attahed by the regulator on produer surplus exeeds the weight plaed on the welfare of the regulated oodity onsuers. Suppose that the politial preferenes of the regulator result in the desire to inrease produer surplus to the level represented by the area BCDE in Figure 1, and that this surplus is saller than the produer surplus orresponding to the onopoly output. In a world pe where heating is perfetly and ostlessly deterred, Q in Figure 1 (where the supersript pe stands for perfet and ostless enforeent ) will be the quota level that ahieves the regulator s objetive, i.e., it inreases the produer surplus to the desired level BCDE. When the onitoring of farers is ostly, however, GF (23) show that the levels of enforeent and prodution depend on the politial preferenes of poliy enforers. In general, the greater is the relative weight θ plaed by the enforeent ageny on produers, the greater is the level of enforeent, and the lower is the above-quota prodution Q. What we will show in this setion of the paper is that, the greater is enforeent and the lower is heating, the greater is the quota level that ahieves the desired surplus transfer to produers. To show this result, onsider first the ase where the enforeent ageny plaes relatively high weight on produer well being [i.e., θ θ in GF (23)]. In this ase, the audit probability θ θ (denoted as δ where the supersript stands for the weight plaed by the enforeent ageny n on produer welfare) is set so that heating is opletely deterred [i.e., δ = δ (where the supersript n stands for no heating ) and Q θ θ =, see GF (23)]. The relevant effetive supply urve of the regulated oodity is depited as the kinked S + MP urve in Figure 1. Q θ θ ( In suh a ase, an output quota set at Q ) will be the optial hoie of the regulator that desires the speifi inrease in produer surplus, i.e., pe Q : p( Q ) Q C( Q ) = BCDE (1) where p( ) is the arket prie of the regulated oodity and C( ) is the total ost of prodution. When the enforeent ageny plaes a positive but relatively low weight on produer surplus [i.e., θ (, θ )], GF (23) show that oplete deterrene of heating is not eonoially n < optial and soe heating will always our (i.e., δ < δ and Q θ θ > ). The relevant θ <θ pe effetive supply urve is shown as the S + MP urve in Figure 1. Under a quota set at Q,

6 Giannakas and Fulton: Effiieny of Output Quotas in the Presene of Cheating 3 the above-quota prodution equals Q and total prodution equals Q* θ <θ ( = Q + Q ). The orresponding arket prie is redued and there is a surplus transfer fro produers to taxpayers through the penalties paid on deteted above-quota prodution (given by the shaded area G). Beause of the inreased prodution and the expeted penalty, produer welfare is redued relative to the perfet and ostless enforeent situation for a quota set at pe Q ( Q when, denoted as given by: Q ). Thus, for the desired inrease in produer welfare to our, the optial quota Q, should be less than pe Q. More speifially, pe Q ' θ < ( Q * ) Q * C( Q * ) [( δ + δ Q ) ρ] Q BCDE θ 1 = will be : p (2) ' where δ 1 is the exogenous oponent of the detetion probability funtion and ρ is the penalty per unit of deteted above-quota prodution [see GF (23)]. P S+ MP S+ MP θ <θ S+ MP θ = k = ( ) p Q* θ <θ ( ) θ =k = ( Q* ) p Q* p B S C S' S' S' θ =k = ( Q* ) θ <θ ( Q* ) ( Q* ) E D G Q =k = Q θ Q D Q pe Q Q* =k = Q* θ Q Figure 1. Welfare Effets of Output Quotas With Cheating Produed by The Berkeley Eletroni Press, 27

7 4 Journal of Agriultural & Food Industrial Organization Vol. 1 [23], Artile 11 Siilarly, when the enforeent ageny plaes no weight on produers and onsuers (i.e., when θ =k= ), enforeent is iniized and above-quota prodution is axiized for any θ = k = given level of quota. The relevant effetive supply urve is given by the S+ MP urve in Figure 1. The quota level that would ahieve the regulator s objetive is given as: Q θ = k= θ = k= θ = k= θ = k= θ = k= ' θ = k= θ = k= ( * ) Q * C( Q * ) [( + δ Q ) ρ] Q = BCDE : p Q Obviously, sine δ θ = k = < δ < δ (= n Q θ = k = < Q < Q δ (3) 1 θ = k = pe δ ) and Q > Q > Q = for any given Q, it will always hold that ( = Q ) i.e., the level of output quota that transfers a given surplus to produers inreases with an inrease in the level of enforeent (and a redution in heating). Following these results, it is easy to deterine the level of total prodution Q* (i.e., output quota plus above-quota prodution) when the objetive of the regulator is to transfer a given surplus to produers. Cruial in deterining the level of total prodution is the transfer fro produers to taxpayers through the penalties paid on deteted above-quota prodution. To show this, note that in a hypothetial ase of no punishent for heating, violation of the quota liit by farers would only require the establishent of the quota suh that the total prodution (output quota plus above-quota prodution) would be at the level that ahieves the desired transfer to produers. When penalties are harged, however, there is surplus transferred fro produers to taxpayers. Beause of this transfer, the total quantity ust be redued further in order for the desired produer welfare inrease to our. In general, the greater is the transfer fro produers to taxpayers, the lower is the total prodution of the regulated oodity. Sine the expeted penalty inreases with an inrease in heating, it always holds that Q* θ = k = < Q* < Q* pe ( = Q* ) i.e., when the objetive of the regulator is to transfer a given surplus to produers, total quantity produed inreases with an inrease in the level of enforeent (and a redution in the level of heating). A onsequene of this is that onsuer surplus falls with an inrease in heating when the objetive of the regulator is to transfer a given surplus to produers. Overall, the analysis shows that both the quota level that transfers a given surplus to produers and the total output produed are greatest when both the regulator and the ageny responsible for the enforeent of the quota progra have a high weight attahed to produer welfare. Both Q and Q* fall with a divergene in the politial preferenes of the poliy aker and the poliy enforer. Ipliit in the above analysis is the assuption that the total surplus BCDE an be ahieved by an appropriate quota under all senarios onerning the enforeent ageny s politial preferenes and prevailing enforeent. However, this is not generally true; not all inoe transfers an be ahieved under heating. Consider the ase where the governent has a very high politial weight attahed to produer welfare and the targeted produer surplus orresponds to the onopoly one. When enforeent is perfet, this requires nothing but the establishent of the quota at the output level deterined by the equality of arginal revenue with arginal osts. Under iperfet enforeent and heating, however, this targeted level of produer surplus is not feasible. The reason is the transfer fro produers to taxpayers through the penalties on deteted heating whenever above-quota prodution ours. Thus, even if the quota was set suh that the total, after-heating prodution would equal the onopoly output, the produer surplus would be less than the one under perfet enforeent of the quota progra. The differene would be the expeted penalties on above-quota prodution. This onstraint on the axiu possible surplus transfer under heating ould result in either the adjustent of the desires of the regulator,

8 Giannakas and Fulton: Effiieny of Output Quotas in the Presene of Cheating 5 or in the use of subsidy payents that would ake up the differene between the desired and the feasible transfer under iperfet enforeent of output quotas [for a poliy ix that obines supply restritions with output subsidies in the presene of heating see GF (2)]. 3. Effiieny in Redistribution The previous setion exained the raifiations of enforeent issues and the politial preferenes of poliy akers and poliy enforers for the ase in whih the purpose of governent intervention is to transfer a given surplus to produers of the regulated oodity. In this part of the paper the welfare losses fro the progra are expliitly linked to the surplus transferred to produers. In the interest group surplus spae, the surplus transforation urve (STC) shows the tradeoff between produer surplus (PS) and onsuer plus taxpayer surplus (CS+TS) for various levels of poliy intervention. The slope of the STC, denoted as s = PS ( CS + TS), is the arginal rate of surplus transforation. It shows the effiieny of output quotas in redistributing inoe to produers at the argin; how uh of an extra dollar taken by onsuers and taxpayers is reeived by produers. The inverse of s gives the arginal ost to onsuers and taxpayers for transferring an extra dollar to produers, while one inus the absolute value of s shows the arginal welfare losses assoiated with the speifi transfer. The loser is s to -1, the saller are the welfare losses, and the greater is the transfer effiieny of the poliy instruent. In a world where progra enforeent is perfet and ostless, the STC of output quotas is pe pe shown as STC in Figure 2. The STC is equivalent to the STC proposed in the traditional analysis of this poliy instruent (Gardner, 1983; Josling, 1974). Point E in Figure 2 orresponds pe to the opetitive output; the point of nonintervention. The STC is onave and reahes its axiu (slope of zero) at the level of quota that equals the onopoly output. Produer surplus inreases at the expense of onsuer surplus for output quotas set between the opetitive and the onopoly output. Further restritions on prodution result in losses for both produers and onsuers. Sine taxpayers are not involved in the surplus trade-off when enforeent is perfet pe pe pe and ostless, the slope of STC an be written as s = PS CS. Consider now the ase where onitoring produers ations requires resoures. Reall that when the weight plaed by the enforeent ageny on produer welfare is relatively high (i.e., θ θ ), heating is opletely deterred by an audit probability that equals δ. Produer and onsuer welfare are the sae as in the perfet and ostless enforeent ase while the taxpayer osts are inreased by the onitoring osts assoiated with δ n n, i.e., (1+d)Φ( δ ) where (1+d) is the arginal ost of publi funds. The slope of the relevant STC, STC θ θ, equals: n s = PS PS = n ( CS + TS ) [ CS + ( + d ) Φ( )] 1 δ (4) pe where CS = CS. The onitoring and enforeent osts result in redued transfer effiieny of the poliy n instruent relative to the perfet and ostless enforeent ase. Sine δ is a dereasing n funtion of Q [i.e., δ ( 1 )( e = b a Q ) ρ ], the greater is the level of intervention (i.e., the 1 Q Produed by The Berkeley Eletroni Press, 27

9 6 Journal of Agriultural & Food Industrial Organization Vol. 1 [23], Artile 11 saller is Q and the further left fro E we ove), the greater is the audit probability that deters heating. Inreased δ results in inreased resoure osts of onitoring and enforeent and redued effiieny of the poliy in transferring inoe to produers of the regulated oodity. Graphially, the inreased enforeent osts result in a leftward elongation of STC pe relative to the STC with the horizontal distane between the two STCs refleting the onitoring osts assoiated with δ n. Both urves reah a axiu at the sae level of produer surplus i.e., the sae level of surplus an be transferred to produers under both situations. PS STC SW SIC SIC STC pe STC θ =k = STC E CS+TS Figure 2. STCs of Output Quotas Under Costly Enforeent [Low Φ(δ o )] When, however, the weight plaed on PS is relatively low [i.e., θ [, θ )], oplete deterrene of heating is not eonoially optial. Above-quota prodution ours and soe part of produer surplus ( R ) is transferred to taxpayers through the penalties paid on deteted ρ over-prodution [i.e., Rρ = ( δ + δ1q ) ρ Q when θ (, θ ), R as: θ = k = ρ θ = k = ' 1 θ = k = θ = k = ' = ( δ + δ Q ) ρq when θ =k=]. The slope of the STC and an be written

10 Giannakas and Fulton: Effiieny of Output Quotas in the Presene of Cheating 7 s = PS PS = ( CS + TS ) { CS + ( 1 + d )[ Φ( δ ) R ]} ρ (5) while the slope of =k = STC θ equals: s θ = k = = PS PS = θ = k = θ = k = θ = k = θ = k = θ = k = ( CS + TS ) { CS + ( 1+ d )[ Φ( δ ) R ]} ρ (6) θ = k = where CS > CS > CS. Siilar to the previous ases, when total prodution falls below the onopoly output produer surplus falls when θ [, θ ). The onsuer/taxpayer surplus is redued initially but rises after the point is reahed where the penalties olleted on deteted heating exeed the resoure osts of onitoring and the loss in onsuer surplus. The result is the bakward bending portion of the STC =k = and STC θ urves in Figure 2. As was pointed out in the previous setion, the transfer R ρ fro produers to taxpayers under iperfet enforeent iplies that in order for a given surplus to be transferred to produers, the output level has to be redued ore than would otherwise be required. This redution in total output results in inreased distortionary osts of arket intervention relative to the perfet and ostless enforeent ase. Moreover, the positive δ that ours when θ [, θ ) eans positive onitoring and enforeent osts. Beause of the inreased resoure osts assoiated with a given transfer to produers the STC =k = and STC θ pe will lie underneath STC everywhere to the left of E. Hene, the ost effiient inoe redistribution through output restritions ours in a world where poliy enforeent is perfet and ostless. The ipliation of this result [whih is onsistent with the findings of GF (2) for the entralized poliy aking ase] is that the traditional analysis of output quotas overestiates the transfer effiieny of this poliy instruent by ignoring the osts assoiated with progra enforeent. Consider next the relative transfer effiieny of output restritions under the different politial preferenes of the enforeent ageny when progra enforeent is ostly. The analysis in GF (23) and the results in the previous setion of this paper show that both enforeent and total prodution inrease with an inrease in the weight plaed by the θ =k enforeent ageny on produers (i.e., δ = θ <θ < δ < δ and Q* θ =k = < Q* θ <θ < Q* ). This finding iplies that an inrease in θ will inrease the transfer effiieny of quotas (i.e., =k = θ <θ s θ < s < s ) as long as the inrease in onitoring osts (assoiated with the higher δ ) is saller than the redution in the welfare losses fro isalloation of resoures (due to higher prodution). Thus, for any given arket onditions, relatively low enforeent osts result in a STC θ =k = that lies under STC θ <θ whih, in turn, lies under STC everywhere to the left of E (Figure 2). More generally, the lower are the enforeent osts, the greater is the likelihood that the transfer effiieny of the poliy instruent inreases with an inrease in θ for any level of arket intervention. If enforeent osts are high, however, this result no longer holds. Sine saller values of θ ean less enforeent and saller output levels, STC θ =k = lies above STC θ <θ whih, in turn, lies above STC. The reason for this ranking is that as θ inreases, the inrease in onitoring osts is greater than the redution in welfare losses that result fro an inrease in prodution. In Produed by The Berkeley Eletroni Press, 27

11 8 Journal of Agriultural & Food Industrial Organization Vol. 1 [23], Artile 11 this ase, the ost effiient outoe eerges under allowane of heating and its attendant derease in total prodution. This is true for the range of intervention where the redution in enforeent osts (due to redued enforeent) outweigh the relevant inrease in deadweight welfare losses. As long as the inrease in the deadweight loss is greater than the redution in onitoring osts, STC will eventually ross STC θ <θ and STC θ =k = fro below (Figure 3). Note also, that beause of the transfers fro produers to taxpayers through penalties on deteted quota violations, the axiu transfer that an be ahieved when soe heating is allowed is always saller than the axiu feasible transfer when heating is opletely deterred. Thus, θ =k = STC and STC θ <θ reah their axiu at a lower level of produer surplus than STC (and STC pe ). PS STC SW SIC SIC pe STC STC θ =k = STC E CS+TS Figure 3. STCs of Output Quotas Under Costly Enforeent [High Φ(δ o )] With this bakground, the relationship between transfer effiieny and the politial preferenes of the regulator and the enforeent ageny an be suarized. When enforeent osts are low, the effiieny of output quotas in transferring inoe to produers is axiized when both the enforeent ageny and the regulator plae a relatively high weight on produer welfare. 2 Interestingly, the transfer effiieny of the poliy ehanis is iniized when the 2 Reall that, sine output quotas involve surplus transfers to produers, a neessary ondition for the adoption of the far progra is a relatively high weight attahed by the regulator to produer surplus.

12 Giannakas and Fulton: Effiieny of Output Quotas in the Presene of Cheating 9 enforeent ageny is not onerned with the welfare of produers and onsuers but its objetive instead is to iniize the taxpayer osts fro heating. The reason is the relatively low level of enforeent that results when the enforeent ageny attahes zero weight to produer welfare. Sine the osts of enforeent are less than the benefits obtained by having greater prodution, the ost effiient outoe eerges under inreased enforeent. While a disagreeent in the politial preferenes of the poliy aker and the poliy enforer is ostly in ters of the transfer effiieny of output quotas when enforeent osts are low, this is not the ase if onitoring osts are high. When enforeent osts are high, the osts of enforeent are greater than the benefits obtained by having greater prodution thus the ost effiient outoe eerges under relatively low enforeent. Sine redued enforeent ours when the enforeent ageny plaes a relatively low weight on produer welfare relative to that of the poliy aker, the ipliation is that a lak of agreeent in politial weighting yields a ore effiient outoe. Overall, the effiieny of output quotas in redistributing inoe to produers of the regulated oodity depends on the level of enforeent and the assoiated onitoring osts. When enforeent osts are low, the effiieny of output quotas inreases with an inrease in enforeent and the redution in heating. When, on the other hand, enforeent osts are high, the transfer effiieny of the instruent depends on the desired transfer to produers. For relatively sall transfers, the transfer effiieny inreases with a redution in onitoring. Beause there is a liit on the axiu inoe redistribution that an be ahieved under iperfet enforeent, the transfer of a large aount to produers an only be ahieved under oplete deterrene of heating. 4. Optial Inoe Redistribution In addition to deterining the onsequenes of heating for the transfer effiieny of output quotas, the STC fraework developed above an be used to deterine the soially optial inoe redistribution when enforeent of the quota progra is ostly. Consider the ase where the objetive of the regulatory ageny is the deterination of the surplus transfer to produers that axiizes soe weighted soial welfare funtion (SWF) (rather that the deterination of the quota level that transfers a given surplus to produers). Assue that the politial preferenes of the regulator result in soial indifferene urves (SICs) siilar to those graphed in Figures 2 and 3, with the SWF value inreasing with the northeast shift of the SIC [for the speifis of the SWF that gives rise to the SICs used in this paper see Gardner (1987)]. The soially optial transfer to produers under the various levels of progra enforeent is deterined by the tangeny of the SIC with the relevant STC (Gardner, 1987). In the relevant area for poliy intervention through output restritions (i.e., the area to the right of the point orresponding to onopoly output), the level of optial total transfer to produers inreases with an inrease in the effiieny of the poliy instruent in redistributing inoe. For any given set of SICs, the axiu transfer to produers will take plae in an environent where heating is perfetly and ostlessly deterred. Sine the transfer to produers under an output quota ours through the arket effets of the poliy instruent, there will be less output produed under perfet and ostless enforeent than when progra enforeent is ostly (i.e., the level of prodution under perfet and ostless enforeent will be loser to the onopoly output). This finding iplies that the traditional analysis of output quotas, by assuing perfet and ostless enforeent of the far progra, inflates the soially optial total transfer to produers, as well as the soial welfare value fro intervention. Produed by The Berkeley Eletroni Press, 27

13 1 Journal of Agriultural & Food Industrial Organization Vol. 1 [23], Artile 11 When progra enforeent is ostly, both the soially optial total transfer to produers and the soial welfare fro intervention inrease with an inrease in enforeent when enforeent osts are low. Put in a different way, when enforeent osts are low both the optial transfer to produers and soial welfare are axiized when the politial preferenes of the enforeent ageny and the regulator oinide, i.e., when produer welfare is valued highly by those responsible for poliy design and enforeent. On the other hand, when enforeent osts are high, the soially optial transfer to produers and the value of SWF fall with an inrease in the level of onitoring (Figure 3). Thus, when enforeent is relatively ostly, both produers and the soiety would be better off in a poliy aking environent haraterized by a divergene in the politial preferenes of the agenies involved in poliy design and poliy enforeent. 5. Extension of the Model - Endogenous Penalties To oplete the analysis of the transfer effiieny of output quotas and the optial regulatory responses to enforeent osts and farer nonopliant behavior, it is useful to onsider the poliy outoes in the liiting ase where penalties are endogenous to the ageny responsible for the enforeent of the progra. Given the results of GF (23) on the optial enforeent of the poliy when the enforeent ageny has ontrol over both audits and penalties harged on deteted above-quota prodution, the ipliations of endogenous penalties for our analysis are straightforward. In partiular, GF (23) show that when penalties are endogenous to the enforeent ageny, the optial hoie of an enforeent ageny that plaes a relatively high weight on produer surplus will be the oplete deterrene of heating through the establishent of enorous fines for those aught violating their quota liit (and no onitoring). Sine, in this ase, enforeent of output quotas is perfet and ostless, the quota level that transfers the desired surplus to produers, the transfer effiieny of the poliy instruent, and the soially optial inoe redistribution are those derived by the traditional analysis of the poliy ehanis. This finding bolsters GF s assertion that, one interpretation of the assuption of perfet and ostless poliy enforeent that is ipliit in the traditional quota analysis is that enorous fines an be ostlessly levied on produers that violate their quota liit [GF (23), p.13]. When, on the other hand, the enforeent ageny plaes a relatively low weight on produer welfare, above-quota prodution ours and the quota level that ahieves the desired transfer to produers is redued relative to the perfet and ostless enforeent ase. Total prodution is also redued. Redued prodution results in inreased welfare losses fro the isalloation of resoures assoiated with a given transfer to produers and, thus in a redued transfer effiieny of the poliy instruent relative to the perfet and ostless enforeent ase. 6. Conluding Rearks This paper extends the study of Giannakas and Fulton (23) on the optial enforeent of output quotas in the presene of heating by exaining the effiieny of the poliy in transferring inoe to agriultural produers as well as the optial regulatory responses under the different enforeent poliy senarios onsidered in GF (23). In partiular, the paper exaines the eonoi onsequenes of enforeent osts and produer nonopliant behavior on the transfer effiieny of output quotas and the level of the soially optial poliy intervention and inoe redistribution in a deentralized poliy aking environent.

14 Giannakas and Fulton: Effiieny of Output Quotas in the Presene of Cheating 11 Analytial results show that the introdution of enforeent osts and heating hanges the inidene of the quota progra. By operating under the assuption of perfet and ostless enforeent of quotas, the traditional analysis of the far progra overestiates the quota level that transfers a given surplus to produers, the transfer effiieny of the poliy instruent, the soially optial total transfer to produers, and the soial welfare value fro intervention. The agnitude of the hanges due to heating (and, thus, the inidene of output quotas) depends on the level of progra enforeent whih is deterined, in turn, by the resoure osts of onitoring produer opliane and the relative weights plaed by poliy enforers on the welfare of the interest groups. On this latter point, when onitoring osts are high, a divergene between the politial preferenes of the poliy aker and those of the poliy enforer results in larger and ore effiient transfers to produers than would our if the preferenes were siilar. When onitoring osts are low, this result is reversed and the larger and ore effiient transfer ours if both poliy akers and poliy enforers have a relatively high weight attahed to produer welfare. The results of this paper deonstrate that enforeent issues relating to output quota shees have signifiant effets on inoe redistribution. They also bolster our previous arguents that enforeent osts and farer nonopliant behavior annot be a atter of indifferene and need to be inluded into the eonoi analysis of the poliy. Finally, it should be noted that, while our study provides insights on the eonoi auses and onsequenes of farer nonopliant behavior, an epirial analysis of heating on output quotas ould ake the analysis of the poliy instruent under ostly enforeent ore useful in pratial poliy settings. Being onstrained by data liitations, we leave this query open to future researh. Aknowledgeents The authors wish to thank Azzeddine Azza and two anonyous Journal reviewers for useful oents on earlier versions of this study. The usual aveats apply. Journal Series No , Agriultural Researh Division, University of Nebraska-Linoln. Konstantinos Giannakas is Assistant Professor in the Departent of Agriultural Eonois and Assoiate Diretor in the Center for Agriultural & Food Industrial Organization at the University of Nebraska-Linoln. He reeived his Ph.D. in Agriultural Eonois fro the University of Saskathewan. His researh interests inlude the areas of industrial organization of the agri-food arketing syste, regulatory eonois and agriultural poliy, applied prodution eonois, and the eonois of agriultural biotehnology. Murray Fulton is Professor of Agriultural Eonois at the University of Saskathewan. He reeived his Ph.D. fro the University of California, Berkeley. His researh and teahing interests are foused on industrial organization, agriultural industry analysis, o-operative theory, intelletual property and biotehnology. Produed by The Berkeley Eletroni Press, 27

15 12 Journal of Agriultural & Food Industrial Organization Vol. 1 [23], Artile 11 Referenes Gardner, B.L., Effiient Redistribution through Coodity Markets, Aerian Journal of Agriultural Eonois 65(1983), , The Eonois of Agriultural Poliies. Maillan: New York, Giannakas, K. and M.E. Fulton, Effiient Redistribution Using Quotas and Subsidies in the Presene of Misrepresentation and Cheating, Aerian Journal of Agriultural Eonois 82(2), , Tough Love: Optial Enforeent of Output Quotas in the Presene of Cheating, Journal of Agriultural & Food Industrial Organization 1(23), Artile 2, Josling, T., Agriultural Poliies in Developed Countries: A Review, Journal of Agriultural Eonois 25(1974),