Setting the deadline and the penalty policy for a new environmental standard

Abstract

A common approach that governments use to combat the potential environmental harm caused by industry is to set an environmental standard for firms to either comply with by a specified deadline or face a penalty. Two penalty policies that governments often rely on to pressure firms to comply with a new standard are a per-period penalty policy and a per-unit penalty policy. We examine how a government should set the deadline and the penalty for a new standard in a market with two competing firms, both of whom make development investment decisions. We analyze and compare the government’s decisions under both penalty policies. Our results show that only when one of the firms has a significantly higher development capability and/or production capability should the government set the deadline in a way such that only one firm complies on time. Comparing the two penalty policies, we find that when the firms’ production decisions are not impacted by the penalty, the government either prefers the per-unit policy or is indifferent between the two policies. Our work adds to the environmental literature on regulatory policy design by examining a government’s deadline choice and penalty decisions (both type and size) for a competitive market with heterogeneous firms.