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Economics Research Institute Study Paper




Utah State University Department of Economics

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In the 1992 Rio Earth Summit, developing countries (DCs) were adamant that in order to protect the environment for the future, new institutions were needed which would channel resources from the wealthy developed countries to the poor DCs. With this backdrop, I analyze the problem faced by an imperfectly informed supra-national govermuental authority (SNGA) with limited financial resources which wishes to design an International Environmental Agreement (lEA). The SNGA cannot contract directly with polluting firms in the various DCs; it must deal with such firms through their governments. I study this tripartite hierarchical interaction and focus on the properties of the optimal limited liability lEA, which can be implemented by the SNGA when governments and firms in the individual DCs collude. I show that obtaining voluntary participation and preventing ex post breach of contract is costly for the SNGA. Further, because the optimal lEA satisfies budget balance, the level and pattern of pollution abatement is typically not ideal. My analysis suggests that lEAs are not inherently doomed due to a basic monitoring and enforcement problem arising from national sovereignty. However, the success of lEAs is fundamentally contingent on the funds available for environmental protection.