A Unified Theory of Institutional Dynamics

"We study an n-country pollution differential game in which countries differ in their sensitivity to environmental damages while contributing to a common pollution stock. Such heterogeneity implies that countries value environmental quality differently and disagree on the desirable long-run environmental outcome. Within a linear-quadratic framework, we characterize the decentralized equilibrium and compare it to a centralized benchmark that maximizes aggregate welfare. We show that decentralized steady-state pollution is inefficiently high and that its level depends systematically on the distribution of damage sensitivities: intriguingly, holding average damages constant, more evenly distributed damages lead to more long-run pollution. We next show, among others, that while polarized damages reduce equilibrium pollution, they do generate distributional tensions. We therefore suggest a mechanism combining Pigouvian taxation with lump-sum transfers that can found an International Environment Agreement redistributing gains and implementing the first-best allocation despite divergent incentives."