Elsevier

Ecological Economics

Volume 47, Issues 2–3, December 2003, Pages 197-212
Ecological Economics

ANALYSIS
Reputation and the control of pollution

https://doi.org/10.1016/j.ecolecon.2003.07.012Get rights and content

Abstract

This paper investigates the effectiveness of reputation in inducing a polluting firm to self-regulate its emissions when consumers have imperfect information. In particular, we ask to what extent must consumers reward and punish the firm before it chooses self-regulation as its dominant strategy? We find that if payoffs in the stage game are such that both the consumer and the polluting firm have beliefs that are consistent with each others' behaviors, then the firm has a positive probability of playing clean in each period of a finite game. Further, we find that a weak reward/punishment scheme may have an adverse effect on the environment, and that there are both environmental and welfare gains associated with strengthening the scheme.

Introduction

Is it possible to control pollution without the involvement of a regulator? On the surface, this question seems heretical. Even though the most appropriate type of regulation for any given pollution problem is still a topic of debate, both experience and theory seem to dictate some form of involvement by a regulatory authority. Indeed, the debate over environmental regulation is typically bounded by the hierarchical questions of: (1) under what conditions are market-based incentives more efficient than command-and-control standards; and (2) assuming that these conditions exist, then whether taxes, transfers, marketable permits, or some combination therein are the preferable mechanisms. As a result of this bounded debate, the basic question has yet to be adequately answered of whether there is a more radical alternative to the ideology of regulator-centric control than these market mechanisms. We show in this paper that such a theoretical alternative may exist. When an unregulated (i.e., “dirty”) firm's reputation both matters and can be updated over time, repeated interactions between the firm and its consumers can lead to self-regulation (i.e., the dirty firm becomes “clean”), even when both the consumers and firm have imperfect information about each other's payoffs.

We find that if payoffs are such that both the consumer and the polluting firm have beliefs that are consistent with each others' behaviors, then in a sequential equilibrium, the firm has a positive probability of behaving clean in each period of a finite game. Further, a weak reward/punishment scheme (i.e., a scheme whereby the consumer does not effectively utilize information about the firm's previous emissions levels to alter his demand) may have an adverse effect on the environment; thus, there are both environmental and welfare gains associated with strengthening the scheme.1 This is good news, as it implies a less active, and presumably less costly, role for the regulating authority. Theoretically speaking, the authority's role might best be relegated to solely pollution monitoring and information dissemination, rather than promulgating technology standards, setting new tax rates, determining permit quotas, or making transfers (each of which typically invokes a weighty political process).

Realistically, will consumers utilize information about firm-level emissions to alter their consumption decisions? How likely are polluting firms to believe that consumers will do so, and thus alter their emissions strategies?2 Empirical research devoted to answering these questions has thus far been too mixed to draw any steadfast conclusions.3 Concomitant with a relatively small amount of empirical research is a dearth of theoretical analysis. For instance, Kennedy et al. (1994) argue that due to market failure, there is a role for public information provision if no other policy instruments are available. In their paper, market failure arises from an unpriced external benefit associated with an “information purchase” by any given consumer, which, in turn, leads the market to underprovide information. What ultimately matters, however, is how firm—not consumer—behavior is changed through information provision. Further, Kennedy, et al.'s model is static and thus incapable of addressing the overriding question of how firm behavior changes over time in response to information provision.

The framework adopted by Cavaliere (2000) is directed toward answering this question, and comes closest to the sequential-equilibrium concept used in the present paper. Cavaliere considers the interactions between a monopolist and a consumer who choose environmental quality with imperfect information. His model is developed for the two-period case. The firm's dominant strategy in the second period is to produce the dirty good, while consumers randomize between dirty and clean goods if the firm produced the clean good in the initial period. Randomization of consumer choices in the final period has a positive effect on the firm's two-period payoffs, thus, it may be in the firm's interest to produce the clean good in the first period and therefore gain the reputation of being a clean firm. A shortcoming of Cavaliere's model is its inability to extrapolate beyond the two-period case and thus test whether or not—and for how many periods—a dirty firm might enhance its reputation by choosing self-regulation as its dominant strategy. Our model builds on Cavaliere's by developing a more general repeated-game framework that extends beyond two periods.

Another interesting paper, by Arora and Gangopadhyay (1995), offers a theoretical explanation for why some firms overcomply with minimum environmental standards. Using a full-information two-stage duopoly model, where in the first stage firms choose their level of cleanup and in the second stage they engage in price competition, the authors show that an a priori clean firm will overcomply when the following two conditions hold. First, due to a presumed availability of public information, consumers are able to perfectly distinguish between the clean and dirty firms based on their respective levels of cleanup. Second, an income differential among consumers is sufficient to support demand for cleaner products at higher prices (i.e., the market is segmented by income level). Arora and Gangopadhyay find that publicly provided information can induce more cleanup by some firms when that information enables consumers to perfectly determine the emissions behavior of firms.4

Applying Backus and Driffill's (1985) repeated-game solution technique to the problem of environmental regulation, we find that under certain circumstances, a polluting firm selects self-regulation as its dominant strategy merely by internalizing the forward effect of its reputation as a clean or dirty firm (or, in terms of Arora and Gangopadhyay, the dirty firm voluntarily overcomplies). Unlike in Arora and Gangopadhyay, this result occurs without consumers having perfect information. Rather, consumers are uncertain of the actual intentions of the firm, and therefore must rely solely on the firm's past behavior in updating their beliefs about the future. Further, a segmented market is unnecessary for self-regulation.

The sequential-equilibrium framework enables us to show under what circumstances a firm is induced by an uncertain consumer to consider the reputational effects of its current and future emissions levels, while satisfying the property of dynamic consistency. In other words, the firm always finds it optimal to stick to its initial plan, whether or not the plan involves becoming clean.5

Previous studies using static models have offered compelling rules that minimize the role of the regulatory authority in controlling pollution, but these rules do not portend to minimize the regulator's role as substantially as that which evolves from the sequential equilibrium investigated here.6 A plethora of regulator-centric dynamic solutions have also been proposed in the literature.7 However, despite their prescriptions of relatively simple regulatory rules that can lead to reduced levels of pollution, none of these studies consider an equilibrium solution that relies entirely on uncertain consumers' abilities to induce self-regulation on the part of the polluting firm. As this paper shows, the mechanism of providing consumers with enough (albeit imperfect) information to distinguish between clean and dirty firms can be, theoretically speaking, adequate enough to control pollution. The regulator's goal is solely to provide consumers with information about the firm's emissions rates; information that enables the consumer to form a reputation that is consistent with the firm's performance over time.

The next section provides a brief overview of current policies that rely on information provision and reputation formation. Section 3 introduces the basic model and discusses its equilibrium properties. Section 4 provides examples of how sequential equilibria are determined for two important cases. Section 5 calibrates the model, and solves for its sequential equilibria under three different information scenarios. Section 6 summarizes and discusses the various policy implications of the analysis.

Section snippets

Policy background

How feasible is a shift away from the current regulator-centric paradigm toward self-regulation? If recent experience is any guide, then it might be feasible for certain classes of externalities under certain market structures. For example, U.S. federal law mandates that the Environmental Protection Agency (EPA) compile information on toxic chemical pollution nationwide in what is known as the Toxic Release Inventory (TRI). Approximately 650 chemicals have thus far been designated for reports

The basic model

Payoffs for each period t of a finite game played between a consumer and any given firm are expressed symbolically in Table 1, where the superscripts on π (profit) and U (utility) denote the four possible outcomes (e.g., superscript 1 denotes the outcome when the firm behaves clean, but the consumer believes that the firm is dirty; superscript 2 denotes the outcome when the firm behaves clean and the consumer believes the firm is clean, etc.).11

Examples of a sequential equilibrium

Table 2 describes the nine possible strategies that a consumer and firm might follow. These strategies result in a total of 81 possible stage games that might be played between the two. For example, the consumer might select her strategy A (the firm is always expected to be dirty) and the firm might select its strategy A (always behave dirty), resulting in stage game AA; or the consumer might select strategy B (the firm is always expected to be clean) and the firm might remain with strategy A,

A numerical example

For this example, we assume that a consumer purchases private goods from two firms—firms 1 and 2—to maximize her utility. Her preferences over these two goods (x1 from firm 1 and x2 from firm 2) and the given aggregate amount of net emissions of a common pollutant produced by the two firms, g, are represented by:U=φx1+(1−φ)x2−0.5g,subject to the budget constraint:Y+t(π12)+w(l1+l2)=p1x1+p2x2.where Y is an initial endowment, t is the dividend rate on firm profits, w is the equilibrium wage

Summary and policy implications

The preceding analysis has demonstrated that consumers' use of information to form reputations of dirty firms is a potentially powerful tool (or, “market mechanism”) in controlling pollution. When a consumer and a firm each follow strategies that are consistent with each other's behaviors, we find that a firm which has the option of behaving dirty (i.e., it may choose not to internalize its contribution to an aggregate externality) nonetheless has a positive probability of playing clean in each

Uncited references

Bierman and Fernandez, 1998

Smart, 1992

Utah Department of Environmental Quality and Division of Air Quality, 2000

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