Optimal environmental regulation of politically influential sectors with asymmetric information

Politically motivated subsidies can have undesired environmental consequences. Asymmetric information regarding firm productivity constrains the government's ability both to redistribute income and control emissions. Taking political and information constraints as given, this article characterizes a social-welfare maximizing policy. The optimal policy uses a single instrument to achieve both goals, making income-support subsidies contingent upon pollution reduction. Price variation allows the government to design contracts with countervailing incentives, potentially eliminating some firms' information advantage.