Optimal Institutional Arrangements for Transboundary Pollutants in a Second-Best World: Evidence from a Differential Game with Asymmetric Players

This paper uses a dynamic model with asymmetric players to explore the question: In a second-best world, should environmental regulations for transboundary pollutants be carried out locally or centrally? We find that combined payoffs are larger with decentralized control if payoffs are sufficiently heterogeneous and initial pollution stocks are sufficiently small. This result is obtained because the central authority applies one shadow price to pollution (i.e., it uses uniform standards), whereas local authorities use different shadow prices, and therefore different standards.