DP11217 | Pollution Claim Settlements Reconsidered: Hidden Information and Bounded Payments

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A pollution-generating firm (the principal) can offer a contract to an agent (say, a nearby town) who has the right to be free of pollution. Subsequently, the agent privately learns the disutility caused by pollution. Then a production level and a payment from the principal to the agent are implemented as contractually specified. We explore the implications of a non-negativity constraint on the payment. For low cost types there is underproduction, while for high cost types there is overproduction. Hence, there may be too much pollution compared to the first-best solution (which is in contrast to standard adverse selection models).