Multiple equilibria in the context of inspection probabilities depending on firms’ relative emissions

Abstract

This paper presents a model of environmental regulations with firms that are heterogeneous with respect to the cost for reducing emissions to the legally permitted level. Given that the enforcement capacity is limited due to budgetary constraints and that each firm's inspection probability depends on its emissions relative to other firms’ emissions, the likelihood of being punished for violations is endogenously determined and multiple equilibria may therefore arise. Hence, both good outcomes with high compliance rates and bad outcomes with many violations are possible. Multiple equilibria are most likely to emerge at intermediate levels of deterrence and at low permitted emission levels. However, it is generally not straightforward how stricter legislation impacts on equilibrium outcomes, indicating that behavioral expectations among regulated firms are an important factor to consider when adapting enforcement to changes in the law.