Comparing Environmental Policy Instruments Within an Incomplete Contract Framework

Abstract

This paper compares three different legal means—no environmental policy (the pollutee pays), full liability (the polluter pays), and pollution standards—to reduce and regulate neighborhood externalities within an incomplete contract framework. It turns out that the relative efficiency of these instruments depends, in general, on details. However, moderate standards are preferable to no environmental policy and tight (but not too tight) standards dominate liability. This provides under the given assumptions (neighborhood externalities, incomplete contracts) a justification for “sensible” standards for three reasons. First, unilateral allocations of property rights are biased that distort allocations even if ex post bargaining takes place. Second, a standard is superior in the following sense: if it is set equal to the outcome under any allocation of rights, it will be improved in the process of ex post bargaining. Third, unilateral property rights encourage strategic ex ante investments up to the point that committing to no bargaining would be beneficial (if possible).