Budget Balancing Incentive Mechanisms

Joseph A. Herriges, Ramu Govindasamy, Jason F. Shogren
October 1992  [92-WP 100]

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Herriges, J.A., R. Govindasamy, and J.F. Shogren. 1992. "Budget Balancing Incentive Mechanisms." Working paper 92-WP 100. Center for Agricultural and Rural Development, Iowa State University.


Xepapadeas [10] develops a pollution abatement incentive mechanism that both reduces the information requirements of regulator and is "budget balancing" drawing only on the social gains from pollution abatement to encourage firm compliance. This paper demonstrates that, contrary to Xepapadeas [10], the budget balancing system of random penalties cannot be used induce compliance with the regulator's objectives if firms are risk neutral. However, the mechanism can be successfully applied if firms are sufficiently risk averse (Rasmusen [9]). Second, the paper explores the optimal design of the random fine system, including the choice of fines, penalty probabilities, and team size.