Optimal Emission Levels When Abatement Costs Are Private Information

Firms are generally reluctant to reveal their true marginal costs for environmental abatement. Depending upon the policy instruments used by the regulator, firms may even seek to misrepresent their abatement costs in order to gain a competitive advantage. This paper shows how the regulator can induce truth revealing behavior by firms in the emission permit market. The aggregate optimal emission level of a particular pollutant is then found by comparing the comparing the market price for emission permits with the inferred price from the known marginal damage function for the same pollutant. The resulting aggregate emission level is shown to be a second-best Pareto-optimal allocation. In addition to showing how to obtain optimal emission levels when firms are unwilling to reveal their true abatement costs, the paper gives insights regarding the design of emission permit markets, and the limitations and possibilities of such markets.