Interstate pollution spillover and setting environmental standards

Abstract

This paper investigates in a multi-level government system, how the federal government sets environmental standards for different states after communicating with state governments regarding the cost of pollution abatement to local economies. Here, the term “federal government” refers to the level of government in a federation responsible for the whole country, while “state governments” are responsible for individual states. We adopt a game-theoretical analysis under asymmetric information where state governments, which know the pollution abatement cost, report to the federal government, which is initially uninformed about the true cost level. We argue that interstate spillover of pollution causes a bias for state governments towards lax environmental standards and gives state governments an incentive to exaggerate the economic cost of pollution abatement. In equilibrium, state governments partition the set of possible costs into disjoint subsets and report the same cost to the federal government under different costs within each partition. After receiving reports, the federal government only knows the partition to which the local cost belongs and sets environmental standards that are not appropriate for the state. On the other hand, when state governments have the authority of setting local standards, the standards are inefficiently lax from a total welfare perspective. The paper compares total welfare levels of all states under the environmental standards set by the federal and state governments. The result indicates that if the degree of spillover is small, the welfare level in the centralized system is less than that in the decentralized system.