Trial runs as environmental policy with strategic firms

Abstract

Since Weitzman (1974) raised a question on which is the better environmental policy tax or standard under asymmetric information, many authors have proposed alternatives to both tax and standard or emission trading scheme. The policy recommended in this paper is also one of them. The policy tells us that the government can set tax rates at arbitrary levels during the trial runs. The government can extract private information from observable abatement activities of firms in the trial periods. However, the government needs not only tax but also the standard for abatement and the penalty against violating the standard, because the firms may respond strategically to the tax rates set in the trial periods. Those supplemental policy devices can eliminate any strategic incentive by equating the marginal benefit and the marginal cost. As a result, we can attain the first best after the trial periods.