Developing countries and environmental protection: the effects of budget balance and pollution ceiling constraints

I analyze the problem faced by an asymmetrically informed supra-national governmental authority (SNGA) with limited financial resources who wishes to design an International Environmental Agreement (IEA). The SNGA cannot contract directly with polluting firms in the various LDCs, and he must deal with such firms through their governments. I study this tripartite hierarchical interaction and focus on the properties of the optimal ex post contracts (IEAs), which can be implemented by the SNGA, in turn, in the case where governments and firms in each nation do not collude and then in the case where governments and firms do collude. I find that the monetary transfers necessary to induce optimal behavior by governments and firms are not very sensitive to the presence of collusion. However, because the optimal contracts satisfy budget balance, and because there is a ceiling on the amount of pollution reduction that an IEA can require, the level and pattern of pollution abatement are typically not ideal. My analysis suggests that IEAs are not inherently doomed due to a basic monitoring and enforcement problem arising from national sovereignty. However, the success of IEAs is fundamentally contingent on the funds available for environmental protection and the pollution reduction ceiling negotiated by the SNGA and the LDC government. (C) 1997 Elsevier Science B.V.