A Standard-Setting Agency and Environmental Enforcement.

• Author: Neilson, William S.

William S. Neilson [*]

Geum Soo Kimt [+]

This paper considers an environmental regulatory agency that sets both the emissions standard and the enforcement parameters in contrast to the usual treatment in which the agency sets only one of the two. It is shown that if the agency's budget is sufficiently small, it sets the strictest possible standard and adopts a policy that minimizes noncompliance with that standard, thus legitimizing the literature that assumes this behavior on the part of the agency. In contrast, if the budget is sufficiently large, the agency can obtain its unconstrained optimum, but this optimum has too little pollution from a social perspective.

1. Introduction

   Environmental regulators set pollution standards, which firms then violate. Consequently, the regulator must also enforce the standard it sets. Studies involving noncompliant firms assume either that the standard is exogenous and the regulator sets the enforcement parameters (e.g., Harford 1978; Garvie and Keeler 1994) or that the enforcement parameters are exogenous and the regulator sets the standard (e.g., Viscusi and Zeckhauser 1979). This study departs from these partial treatments of the problem by allowing the regulator to set both the standard and the enforcement parameters, which matches the assignments of many environmental agencies. [1]

   Studies of regulator behavior typically specify an objective function that matches the scope of the regulator's duties. For example, when the standard is exogenous and the regulator sets only the enforcement parameters, it is typically assumed that the regulator tries to minimize noncompliance with the standard (e.g., Garvie and Keeler 1994; Keeler 1995). On the other hand, when the regulator sets the standard, some sort of social welfare maximization is assumed (e.g., Viscusi and Zeckhauser 1979; Jones and Scotchmer 1990). Formal theories of regulation, however, typically assign different objectives to the regulator. In his theory of bureaucratic behavior, Niskanen (1975) assumes that agencies attempt to maximize their budgets, [2] while in his theory of regulation, Peltzman (1976) posits that agencies maximize net political support. In this paper we examine the problem of an agency that cares about both the size of its budget and its political support when it sets and enforces an environmental standard.

   It is assumed that the regulatory agency cares about how much it spends as well as the well-being of the regulated industry and the environmental lobbies, with its first priority being the depletion of its externally set budget. It is shown that the agency's choices depend on the size of its budget. There are two cases. If the budget is small, in a sense made explicit in the following, the agency sets the emissions standard as tight as possible and then sets the enforcement parameters so as to minimize noncompliance with the selected standard. On the other hand, if the budget is sufficiently large, the agency is able to achieve its unconstrained optimum, and further increases in the budget have no effect on the equilibrium levels of output and pollution. Furthermore, the agency can achieve these desired levels using many different combinations of standards and enforcement parameters. [3] From a social viewpoint, though, the agency allows too little pollution because the agency ignores the effects of regulati ons on consumers. This suggests that it may not be best to let a well-funded agency both set and enforce a standard.

   Section 2 introduces the model and analyzes both the firms' and the agency's optimization problems. Section 3 discusses characteristics of the equilibrium of the game between the agency and the firms. Section 4 provides some concluding remarks.

2. The Model

   There is an environmental regulatory agency that announces and commits to an environmental standard and enforcement parameters. There are n identical firms that take the standard and enforcement parameters as given, and maximize their expected profits by deciding how much output to produce and how much waste e to discharge. They do not comply with the standard if the benefits from noncompliance exceed the expected fines. With probability p, the agency monitors and detects a violation. If the agency finds that a firm is violating the standard, it brings the evidence to the judiciary and asks it to review the evidence in light of the relevant statutes and impose some penalty. The agency cannot directly impose a fine but can merely influence the penalty through legal expenditures. Of course, the defendant can also spend money trying to avoid the fine, but that expenditure is left out of the model for the sake of simplicity. [4] The fine resulting from a violation of magnitude v = e - s when the agency's legal e xpenditure E is given by the function F(v, E). It is assumed that F is increasing in both arguments, that [F.sub.vv], [greater than] 0, and that [F.sub.vE] [greater than] 0, so that an increase in legal expenditure leads to an increase in the marginal fine. [5]

   Given that the agency sets the policy parameters first and the firms respond optimally to the announced parameters, the agency behaves like a Stackelberg leader. In other words, the agency chooses the standard and regulatory parameters incorporating the best responses of the firms. So, the analysis begins with the firm's problem. The firms are assumed to be identical in the sense that they participate in a constant cost industry with the same production technology. A typical firm's decision problem can be written as

   [max.sub.x,e] R(x, e) - rx - pF(e -- s, E)...