Stochastic pollution, permits, and merger incentives

Pollution permit regulations introduce nonlinearities into the objective function of a polluting firm. We develop a microeconomic model to show the effects these nonlinearities might have upon firm decisions when emissions are stochastic. Under perfect competition the fraction of planned pollution covered by permits is shown to be separable from planned production. We also demonstrate that permit management incentives may motivate a merger of otherwise independent firms. Incentives to petition for 'bubble' coverage are also considered. The model is studied under risk neutrality and risk aversion. Imperfectly competitive situations in the output and permit markets are also analyzed.