On the dynamics of the regulation of pollution: Incentive compatible regulation of a persistent pollutant

Consider the optimal regulation of a persistent pollutant. Because the pollutant is persistent, the levels of pollution in neighboring periods are causally related, and it is necessary to determine an optimal trajectory of emissions. The optimal level of emissions in any period depends on the costs to reduce emissions, but these costs are generally private information to the polluting firms. A regulatory agency may solicit firms' cost functions, but if the firms know how the agency will use the information they provide, they may have an incentive to lie. Hence the agency's problem is to design a regulatory scheme that elicits truthful responses from firms and achieves the optimal trajectory of emissions. This paper describes such a scheme, the extension to a dynamic setting of a scheme found by Evan Kwerel. The purpose of this paper is to describe: this "dynamic Kwerel scheme," derive its properties, and describe the associated trajectory of emissions. (C) 1998 Academic Press.