Imperfect verification,appeals, and limited liability

We examine the effect of an imperfect verification and a subsequent appeals process in regulatory settings where legal or institutional restrictions impose an upper bound on penalties. We show that the verification always enhances social welfare despite the limit on penalties. The subsequent appeals process, which allows the firm to challenge an unfavorable finding by the regulator, is never socially optimal when it is costless. However, when the appeals process is costly, it can be optimal even if it is less accurate than the verification. Moreover, social welfare can increase as the cost of the appeals process increases.