Markets and regulatory hold-up problems

Many regulatory programs such as environmental regulation are effective onl y if firms make irreversible investments that reduce the cost of compliance . A firm potentially subject to regulation may therefore behave strategical ly by not investing, thereby forcing the regulator to void the proposed reg ulation. We show that such incentives, which resemble a hold-up problem, ma y not be overcome when government's only tool is the imposition of an emiss ions tax. The hold-up problem can be overcome by the issuance of tradeable permits. A time-consistent equilibrium exists with all firms investing and the government imposing regulations, even if no permits are traded and thei r market price is low. Indeed, an observation of no trade may indicate that pollution abatement is great. (C) 1999 Academic Press.