Noncooperative Regulation of a Nonlocalized Externality

Noncooperative Regulation of a Nonlocalized Externality

1984Working Paper No. 757

A nonlocalized pollution externality poses special regulatory problems when both a) the costs and benefits of abatement are borne by different persons and b)the interests of the two groups are represented by different regulatory agencies. A relevant example is acid rain for which consumers and producers of electricity in the Midwest are likely to bear the costs of abatement, while the residents of the Northeast receive the benefits of abatement. The interests of Midwestern consumers and producers are the responsibility of a state public utility commission (PUC), and the interests of residents of the Northeast are represented by the EPA. Given the conflicting interests of the regulators and incomplete information about abatement costs and benefits, the regulators may not have an incentive to cooperate in the regulation of pollution and prices. A regulatory game is formulated in which each regulator controls regulatory instruments that affect the operations of a firm which is better informed about the cost and effectiveness of abatement alternatives than is either regulator. The analysis predicts that the EPA will act as a Stackelberg leader with respect to the PUC, and a regulatory equilibrium is characterized.