Regulation and Coordination of International Environmental Externalities with Incomplete Information and Costly Public Funds

In this article, we study cross‐border externalities in a game played by two principal‐agent pairs with adverse selection. Each firm/agent is located in one country and generates pollution by producing complementary or substitute goods, sold on a common market. A fraction of pollution is transferred from one country to another. Each regulator/principal is imperfectly informed about the marginal cost of his domestic firm and accordingly uses secret incentive contracts with costly public funds. We show the necessity of cooperation between competing regulators to effectively internalize all the damages caused to the environment, while reaching the first best. If the level of uncertainty is sufficiently low, we obtain an infinity of noncooperative Bayesian differentiable equilibria, which may necessitate competing regulators to coordinate on an equilibrium. Such coordination constitutes an incentive for competing regulators to cooperate. Our major result states that under some circumstances asymmetric information relaxes the transborder externality problem. Indeed, we show that, when there is a major transfer of pollution and firms' marginal costs are sufficiently high, competing regulators are better off under uncertainty. Therefore, asymmetry of information can have the very consequence of generating regulation that is too strict from the domestic viewpoint but that improves social efficiency when the benefits to both countries are taken into account.