Regulation of Prices and Pollution Under Incomplete Information

The regulation of prices and pollution for a regulated monopolist is considered with a focus on the comparison of standard-setting and emissions taxation approaches to pollution control. The firm is assumed to be better informed about the costs and effectiveness of abatement technologies than is either regulator. If information were complete the two approaches to pollution control would be equivalent, but with incomplete information emissions taxation is shown to be a dominated approach because the use of a tax generates information costs that can be avoided when an abatement standard and prices are set by the regulator. If a taxation approach were used in which the choice of the abatement standard were delegated to the firm, the firm would in the optimal regulatory policy choose a standard that is lower than the regulator prefers. Furthermore, the emissions tax would be set below the marginal value of abatement. An example demonstrates that the emissions taxation approach results in a lower technology standard and a lower price than does the standard-setting approach.