Two major policy objectives of environmental regulators are to choose appropriate levels of pollution abatement and to minimize the cost to firms of achieving abatement targets. Many existing environmental regulations are difficult to rationalize on these grounds if the regulator is fully informed. However, environmental regulatory policy is often designed without complete information about the economic cost of abatement. This paper shows that, in the case of incomplete and asymmetric information, least-cost regulations such as abatement quotas are often dominated by regulations that distort a firm's incentives to minimize costs.

It is difficult to set standards that equate the marginal benefit with the marginal cost of pollution abatement when that cost is unknown. However, a firm can be induced to reveal implicitly information it has about abatement costs by allowing it to choose from a menu of judiciously designed regulatory contracts. By anticipating the strategic response of the firm, a regulatory agency can structure regulations to better achieve the objective of choosing the appropriate abatement level. One well-known, but expensive, way to elicit the firm's private information is to offer an appropriate monetary reward.

We show that, alternatively, the regulator can the elicit private information by the use of non-monetary rewards. For example, linking abatement standards to production or input levels provides a non-monetary economic reward that the regulator can manipulate. A menu of regulatory contracts that specify abatement standards and corresponding permissible production levels, pollution-per-unit-output for example, allows the regulator to require implicitly differing abatement levels corresponding to differing efficiency levels. The distortionary aspects of these regulations are necessary to give firms a strategic incentive to reveal their private cost information. The induced separation of firms into low and high cost groups, and the corresponding difference in abatement requirements generates the desired outcome in terms of economic efficiency: firms with low costs of production and abatement engage in more of both activities.