, Volume 50, Issue 3, pp 325-346
Date: 09 Apr 2011

Frontrunners and Laggards: The Strategy of Environmental Regulation under Uncertainty

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Abstract

The extant literature on the political economy of environmental regulation does not provide a unified theoretical explanation for three salient stylized facts. First, companies voluntarily invest to reduce the environmental burden that they cause under threat of regulation. Second, ex ante estimates of the compliance cost tend to be systematically higher than ex post estimates. Finally, regulators use limited information provided by the industry. I construct a game-theoretic model of environmental regulation under uncertainty with a benevolent regulator. In equilibrium, companies undertake voluntary action to induce regulation that raises barriers to entry. This profit-driven behavior is not always socially detrimental, however, as the regulator obtains a credible commitment to production and a more accurate estimate of the compliance cost. Additionally, the results provide a selection explanation for the mismatch between ex ante and ex post cost estimates: if companies condition compliance on the installation cost, only low-cost companies install in equilibrium. The analysis combines “regulatory capture” with social welfare maximization to explain the curious combination of voluntary action and low ex post compliance cost without serious information collection by the regulator.

I presented this research at an internal seminar in the Department of Economics at the University of Michigan. I am grateful to Vincenzo Denicolò, Tom Lyon, John Maxwell, the anonymous reviewers, and the editors of Resource and Environmental Economics for advice.