W7 - Environmental Regulation Under Asymmetric Information: Adverse Selection and Moral Hazard

Question 1

What is asymmetric information, the objective of regulators, the general problem and the general solution?

Answer 1

Different level of access to relevant information between parties

Optimal level of x

Regulators and polluters interests are not aligned (principle-agent problem)

Create a regulatory framework that aligns incentives

Question 2

Draw a graph of the asymmetric information problem with two firms with high/low abatement costs - indicate the resulting losses

For a tax/quantity standard - what is the incentive to lie about your abatement costs?
What is the consequence?

Answer 2

Okay

For tax incentive to signal you are low, for quantity standard high.

When your fee is too large, forces you to abate too much and may force you to exit the market

Question 3

What is the general solution of asymmetric information? i.e. what is the framework

Answer 3

For a tax provide a reward of the right size to induce H to self reveal while not inducing L to say they are H

Question 4

Where should you set the price or quantity with asymmetric information?

Answer 4

Set price if MD more elastic than MS
Set quantity if MS more elastic than MD

Question 5

Draw a graph of welfare loss from a quantity and price instrument

Answer 5

okay

Question 6

Empirically, do we see more quantity standards or price caps and why

Answer 6

Quantity standards
- Pollution threshold effect
- Gives peace of mind
- Easier for big firms to lobby to influence permit allocations

Question 7

How would a hybrid system of both quantity and price controls work?

Answer 7

Sets quantity standard via estimated MS
offers subsidy for excess emission reduction
unit taxes excess emission pollution

Question 8

Draw a graph of how a hybrid system would work

Answer 8

Okay

Question 9

Setup and explain the effect of hidden action (using graph)
Give the function and variables
What is the regulators and firms objectives.

Answer 9

One regulator and one polluter
emissions (e) are a function of abatement equipment (a) and effort levels (f) so e = e (a,f)
a is observable but f is hidden

Regulators objective is to minimise social cost and wants optimal f*
Firms objective is to minimise private costs and so will choose a low effort level

Result - need more abatement equipment to compensate for low effort level (shift MD curve up)

Question 10

What is a generic solution to hidden action (moral hazard)?

Answer 10

Set incentive so firm takes care, find a proxy for effort level (f) such as how many people working on maintenance

Question 11

Draw a graph of how a deposit-refund scheme would work

Answer 11

okay
Subsidy makes safe disposal cheaper, fee makes factory pay for harm the waste causes

Question 12

Give the toxic waste dumping case study n Italy

Answer 12

High death/cancer rates around Naples
Camorra cartel ran an illegal toxic waste disposal business for cheap without concern for the environment, had lots of political power especially at local level
Over 10mn tonnes waste dumped
National government knew, but only recently started enforcement due to public protests
Now shipping waste to Africa and E. Europe

Question 13

Draw the compliance and non compliance graphs of enforcement, assuming the regulator can audit firms to tackle info asymmetry

Answer 13

Okay

Firms operate where MS (pollution) = Expected marginal fine

Question 14

What are the 2 ways for regulators to improve compliance?

Answer 14

1) Increase probability of punishment (change frequency of audits based on past performance)
2) Penalty size