Optimal environmental regulation under asymmetric information

A market model of environmental regulation with interdependent production and pollution abatement costs and heterogeneous firms is developed. Firms have private information about costs which have a quadratic form. Firms pursue Bayes-Nash strategies in communication with the regulator. The full information optimum cannot be attained unless gains from trade in the product market net of external damages exceed the information rents earned by firms. Aggregate output and externality levels are lower at the regulated equilibrium than at the full information social optimum.