Stochastic pollution, permits, and merger incentives

Pollution permit regulations introduce nonlinearities into the objective fu nction of a polluting firm. We develop a microeconomic model to show the ef fects these nonlinearities might have upon firm decisions when emissions ar e stochastic. Under perfect competition the fraction of planned pollution c overed by permits is shown to be separable from planned production. We also demonstrate that permit management incentives may motivate a merger of oth erwise independent firms. Incentives to petition for "bubble" coverage are also considered. The model is studied under risk neutrality and risk aversi on. Imperfectly competitive situations in the output and permit markets are also analyzed. (C) 1999 Academic Press.