The deterrence effect of linear versus convex penalties in environmental policy: laboratory evidence

We study the individual compliance behavior of polluting firms in an experimental setting under two different penalty functions (a linear and a strictly convex) and two different regulatory instruments (emission standards and tradable pollution permits). We find that a convex penalty, as compared to a linear penalty, increases the market price of pollution permits and the violation rate of firms. The effect of the structure of the fine on the price of permits operates through an increase in the ask-prices of sellers, not on the bids by suppliers. With convex penalties, sellers are not willing to sell a permit at a price as low as with linear penalties. We do not observe an effect of convex penalties on the compliance status of firms with emission standards. These results call for attention on the possible effect that the type of penalties may have on the cost-effectiveness of pollution control programs based on tradable pollution permits.