Performance, Process, and Design Standards in Environmental Regulation

This papers analyzes efficient regulatory design of a polluting firm who has two kinds of private information about its production environment. First, the firm has better information than the regulator regarding technological possibilities for controlling pollution; and second, some aspects of the firm's implementation of a given technology are potentially unobservable. Design standards that specify a particular pollution abatement technology for the firm are efficient when the level of information asymmetry regarding technology choice is low, and when the cost of performance measurement is high; performance standards are efficient when the level of penalty needed to induce efficient implementation is unlikely to bankrupt the firm; and process standards are efficient when it is not very costly to monitor firm actions. We identify circumstances when each individual regulatory instrument (design, performance, and process standards) alone or in some combination is efficient.