Some Aspects of Incentive-Based Optimal Pricing and Environmental Regulation with Asymmetric Information.

Abstract

The paper aims to analyze the problem of regulating a pollution-generating single product monopolistic firm in the presence of information asymmetry about the firm?s cost performance. Following Boyer and Laffont (1999), incentive-based optimal regulation of the firm?s price/ output and the environmental performance is characterized when costs are increasing in output and declining in pollution generated during production. Further, the regulatory agency/ legislator may or may not be politically motivated. When he/ she is politically inclined, the process of lobbying assumes that interest groups offer monetary contributions to the regulatory agency or the legislator. These contributions from the lobby help fund election campaigns. Thus, he/ she no longer behaves as a benevolent maximizer of social welfare, but instead maximizes a weighted average of social welfare and welfare of the lobby. Two alternative cases are considered: one, where the lobby represents environmental interests alone, and another, where the lobby stands solely for firm?s/ industry?s interests. The analysis derives interesting implications for incentive-based regulation of the firm. In general, pricing and environmental performance are distorted for the inefficient firm type under asymmetric information to restrict rents accruing to the efficient firm type. In the presence of the environmental lobby, the politically inclined regulator imposes more stringent environmental regulation under both full information and incomplete information as compared to the no-lobbying case. Interestingly, lobbying by the firm/ industry group also induces the politically motivated regulator to have more restrictive environmental regulation, albeit it now combines it with a higher regulated output for the inefficient firm type under incomplete information vis-…-vis the case of no-lobbying activity.