Regulation with Budget Constraints Can Dominate Regulation by Price and by Quantity

A government can use several mechanisms to induce firms to reduce pollution. Well studied are regulations by price and by quantity. We consider a third form of regulation -- government allocates a budget to an agency which subsidizes abatement. We demonstrate that uncertainty can make such constrained regulation more efficient than either regulation by quantity or regulation by price. We also show that the optimal budget declines with a mean-preserving spread in the distribution of marginal costs.