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Environmental Regulation

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Department of Agricultural and Resource Economics The University of Maryland, College Park Environmental Regulation in Vertically Coordinated Industries by Rimjhim Aggarwal and Erik Lichtenberg WP 01-13ENVIRONMENTAL REGULATION IN VERTICALLY COORDINATED INDUSTRIES by Rimjhim Aggarwal ([email protected]) and Erik Lichtenberg ([email protected]) Department of Agricultural and Resource Economics University of Maryland College Park, Maryland 20742-5535 Abstract Many notable pollution problems occur in industries where production is carried out under vertical coordination arrangements that are characterized by conditions of double moral hazard. In contrast to situations characterized by full information, we show that standard prescriptions of environmental economics do not apply. Imposing a Pigouvian tax equal to the marginal cost of pollution does not lead to the first best level of pollution. The equilibrium levels of production and pollution are not independent of which agent is taxed. Making either agent or the industry as a whole financially liable for full environmental damage at the margin similarly does not lead to a first best level of pollution. On the contrary, under conditions of double moral hazard, the industry should pay for less than the full cost of environmental damage. At present, only one agent (if any) is typically liable for environmental damage. We derive conditions under which imposing new regulations that make only one agent financially responsible for the full cost of environmental damage (as conventional wisdom in environmental policy suggests) is excessively stringent in that it results in pollution and production that are less than the first best levels. We also show that such new regulations could result in negatively correlated deviations of pollution and production from their first best levels, a situation that cannot arise under conditions of complete information. JEL Classification: Q2, L51, L22, K32 Keywords: Environmental regulation, pollution, vertical coordination, double moral hazard, livestock Acknowledgements: This research was supported by the U.S Department of Agriculture National Research Initiative Competitive Grants Program under Cooperative Agreement No. 99354007797. We are grateful to Bob Chambers, Ethan Ligon, Tigran Melkonyan, David Zilberman, and seminar participants at Columbia University, the University of California-Berkeley, and the University of Texas-Dallas for their comments and suggestions. Responsibility for errors is, of course, ours alone. November 7, 2001 Copyright © 2001 by Rimjhim Aggarwal and Erik Lichtenberg. All rights reserved. Readers may make verbatim copies of this document for non-commercial purposes by any means, provided that this copyright notice appears on all such copies.Environmental Regulation in Vertically Coordinated Industries Rimjhim Aggarwal ([email protected]) and Erik Lichtenberg ([email protected]) Department of Agricultural and Resource Economics University of Maryland College Park, Maryland 20742-5535 This research was supported by the U.S Department of Agriculture National Research Initiative Competitive Grants Program under Cooperative Agreement No. 99354007797. We are grateful to Bob Chambers, Ethan Ligon, Tigran Melkonyan, David Zilberman, and seminar participants at Columbia University, the University of California-Berkeley, and the University of Texas-Dallas for their comments and suggestions. Responsibility for errors is, of course, ours alone. November 7, 2001Environmental Regulation in Vertically Coordinated Industries I. Introduction On January 12, 2001 the U.S. Environmental Protection Agency (EPA) published proposed new regulations to address surface and ground water pollution from animal feeding operations, which have been identified as one of the major environmental problems in many parts of the U.S.). A large proportion of animal feeding operations are currently carried out under vertical contracts between processors and growers. For instance, the broiler industry has been identified as a major source of water quality problems in the Chesapeake Bay and elsewhere; virtually all broiler production occurs under vertical contracts (Economic Research Service 1996). Similarly, odor and water pollution from concentrated hog production facilities are sources of bitter controversy in states where vertical contracts have led to the spread of concentrated swine production. In these contracts, both parties contribute essential inputs into the production process but the responsibility for managing pollution falls on growers, who own the facilities from which environmental damage emanates. The proposed regulations will, if finalized, make processors partially responsible for managing animal waste. Several states, notably Kentucky and Maryland, have adopted similar regulations imposing joint legal liability for animal waste management on processors and growers. How to apportion liability between the two contracting parties is obviously important here but neither EPA nor the states have addressed this issue in specific terms. It is well known that in the presence of competitive markets and full information, assigning liability to any party across a vertical chain is equivalent in terms of efficiency. However, when one of the markets is not competitive then, as Sunding and Zilberman2 (1998) show, the assignment of liability matters and the relative efficiency of different liability regimes depends amongst other things on market conditions and the nature of the hazardous product. Sunding and Zilberman’s analysis assumes that there is full information. This assumption is hard to justify in the above discussed cases of vertical contracting because one of the important reasons why contracting is preferred over market transactions in these instances is because agents along the vertical chain have asymmetric information leading to market failure. The question of how different liability regimes (joint versus making a single party responsible) compare in terms of economic efficiency in such a vertical contracting context has not been rigorously analyzed. With the spread of contracting generally in the economy (as well as within the livestock sector) and the contemporaneous increase in awareness of pollution problems, the question of the appropriate apportionment of responsibility for pollution control among contracting parties arises


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