Regulating Nitrogen Pollution with Risk Averse Farmers Under Hidden Information and Moral Hazard

Abstract

We consider a model of pollution regulation for a risk averse farmer involving hidden information, moral hazard, and risk‐sharing. The representative farmer faces a production risk originating from nitrogen leaching, and privately observes the soil capacity in retaining nitrogen only after the regulation contract is signed. The latter specifies a transfer and a nitrogen quota, whose decomposition by the farmer among different production stages is unknown to the regulator. We first characterize the optimal solution to the regulator's problem. The sequential decision model is estimated on French crop production data, and the results are used to calibrate and simulate the optimal contract.

Keywords: asymmetric information, mechanism design, moral hazard, nonpoint source pollution, risk aversion, split nitrogen application