Moral hazard, risk aversion and compliance monitoring in agri-environmental policy

Agri-environmental policy is modelled as a social welfare maximisation prob lem that recognises the potential trade-off between increased environmental benefit and increased cost of monitoring compliance. Moral hazard arises b ecause monitoring does not detect all those who fail to comply with contrac tual obligations. It is shown that if monitoring costs are negligible or fi xed. or farmers are highly risk averse, the moral hazard problem can be eli minated. However, if monitoring costs depend on monitoring effort and the d egree of risk aversion is low, only a second-best solution can be obtained. Numerical simulations suggest that optimal monitoring effort declines with increasing farmer risk aversion.