The Problem of Shared Social Cost

Abstract:     
This paper presents a mechanism for regulating pollution when industry harm - but not individual firm's contributions - is observable. The mechanism is based on a modification of Cooter and Porat's Total Liability for Excessive Harm (TLEH). We propose an alternative mechanism of Shared Social Costs (SSC), where firms share the total cost of industry harm and abatement costs. In cases where the abatement costs for each firm are verifiable, SSC may provide an efficient alternative to TLEH.

The mechanisms are largely equivalent, but require different types of information for the regulator. For a legal target to be set in TLEH, it requires either knowing the cost functions of individual firms or accommodating error costs by gradually reducing the legal target until the efficient level is found. On the other hand, SSC requires observing individual firms actual abatement expenditures as opposed to knowing their cost functions. Both rules provide efficient incentives for abatement, and require being able to observe and monetize industry level harm.

We show that SSC leads to efficient incentives for entry and exit, has appealing incentives for innovation, and can be applied advantageously to remediation. In markets with heterogeneous firms, we propose weighting cost-sharing by firms' market shares.

Keywords: tort law, liability, environmental regulation, total liability, asymmetric information

JEL Classifications: K13, K32, L51

Working Paper Series