Environmental Regulation In Vertically Coordinated Industries

Many notable pollution problems occur in industries where production is carried out under vertical coordination arrangements that are characterized by conditions of double moral hazard. In contrast to situations characterized by full information, we show that standard prescriptions of environmental economics do not apply. Imposing a Pigouvian tax equal to the marginal cost of pollution does not lead to the first best level of pollution. The equilibrium levels of production and pollution are not independent of which agent is taxed. Making either agent or the industry as a whole financially liable for full environmental damage at the margin similarly does not lead to a first best level of pollution. On the contrary, under conditions of double moral hazard, the industry should pay for less than the full cost of environmental damage. At present, only one agent (if any) is typically liable for environmental damage. We derive conditions under which imposing new regulations that make only one agent financially responsible for the full cost of environmental damage (as conventional wisdom in environmental policy suggests) is excessively stringent in that it results in pollution and production that are less than the first best levels. We also show that such new regulations could result in negatively correlated deviations of pollution and production from their first best levels, a situation that cannot arise under conditions of complete information.