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UNIVERSITY OF ILLINOIS LIBRARY AT URBANA-CHAMPAIGN BOOKSTACKS CENTRAL CIRCULATION BOOKSTACKS The person charging this material is re- sponsible for its renewal or its return to the library from which it was borrowed on or before the Latest Date stamped below. You may be charged a minimum fee of $75.00 for each lost book. Theft/ mutilation, and underlining of book* ore reasons for disciplinary action and may result In dismissal from the University. TORENEWCALLTELEPHONECENTER, 333-8400 UNIVERSITY OF ILLINOIS LIBRARY AT URBANA-CHAMPAIGN AUG 1 1997 When renewing byphone,writenewduedatebelow previous due date. L162 Faculty Working Paper 92-0112 Political Economy Series #55 STX 330 B385 1992:112 COPY 2 Regulating a Stock Externality Under Uncertainty with Learning Charles D. Kolstad Department ofEconomics Bureau of Economic and Business Research College of Commerce and Business Administration University of Illinois at Urbana-Champaign Papers in the Political EconomyofInstitutionsSeries No.24 HadiS. Esfahani. "Moral Hazard, Limited EntryCosts, and IntroductoryOffers'"WorkingPaper#89-1526 No.25 BhaskarChakravorti. "Mechanisms withNoRegret: WelfareEconomicsand Information Reconsidered"Working Paper#89-1527 No.26 Susan I.Cohen. "ImplicitCostAllocation and BiddingforContracts' WorkingPaper#89-1558 No.27 RafaelGelyandPabloT. Spiller. "ARational ChoiceTheoryoftheSupremeCourt" WorkingPaper#89-1559 No.28 Rafael Gelyand PabloT. Spiller. "An EconomicTheoryofSupreme CourtStatutoryDecisionsTheStateFarm and Grove City Cases"Working Paper#89-1560 No.29 Rafael Gelyand PabloT. Spiller. "The Political EconomyofSupremeCourtConstitutional Decisions:TheCaseofRoosevelt'sCourt Packing Plan" WorkingPaper#89-1561 No.30 HadiS. Esfahani. "Reputation and ProductQuality Revisited." Working Paper#89-1584 No.31 Jan K. Brueckner. "Growth Controlsand Land Valuesin an Open City." Working Paper#89-1594 No.32 Jan K. Brueckner "Tastes,Slr.ils,and Local PublicGoods." WorkingPaper #89-1610 No.33 LuisCabral andShaneGreenstein. "SwitchingCostsand Bidding Parityin Government ProcurementofComputerSystems." WorkingPaper#90-1628 No.34 Charles D. Kolstad. "HotellingRentsin HotellingSpace: ExhaustibleResourceRents with Product Differentiation." Working Paper #90-1629 No. 35 SantiagoUrbiztondo. "InvestmentWithoutRegulatoryCommitment: TheCaseofElastic Demand." WorkingPaper#90-1634 No.36 BhaskarChakravorti. Sequential Rationality, Implementation and Communication in Games." Working Paper#90-1636 No.37 PabloT. Spiller, Rafael Gely. "Congressional Control ofJudicial Independence: The DeterminantsofUSSupremeCourt Labor Relations Decisions, 1949/1987."WorkingPaper#90-1637 No.38 Hans Brems. "DynamicMacroeconomics: Fiscal and Monetary Policy."Working Paper#90-1640 No.39 LannyArvan. "Flexibility Versus Commitmentin StrategicTrade Policy Under Uncertainty: A Model ofEndogenous Policy Leadership."WorkingPaper#90-1651 No.40 DavidT. Scheflman, PabloT. Spiller. "Buyers'Strategies, Entry Barriers, andCompetiton." Working Paper#90-1674 No.41 Richard Arnouldand LarryDeBrock. "UtilizationControlin HMOs." WorkingPaper#90-1698 No.42 ShaneGreenstein. "Did Installed BaseGive an IncumbentAny(Measurable) Advantagesin Federal Computer Procurement?"WorkingPaper#90-1718 No. 43 BhaskarChakravorti and Charles M. Kahn. "UniversalCoalition-ProofEquilibrium" WorkingPaper#91-0100 No. 44 PabloT. Spiller. "A Rational ChoiceTheoryofCertiorari: Hierarchy, Strategyand Decision CostsattheCourts' Working Paper#91- 0110 No.45 PabloT Spiller. "Agency Discretion UnderJudicial Review"Working Paper #91-0111 No. 46 Charles D. Kolstad andMichelle H.L.Turnovsky. "Production with Quality Differentiated Inputs' WorkingPaper#91-0118 No. 47 PabloT. SpillerandSantiago Urbiztondo. "Political Appointeesvs. CareerCivil Servants:AMultiple PrincipalsTheoryofPolitical Bureaucracies" WorkingPaper#91-0129 No.48 ShaneM. Greenstein. "Lock-In and theCosts ofSwitching MainframeComputerVendors: What DoBuyersSee?" Working Paper #91-0133 No. 49 PabloT. SpillerandMatthew L. Spitzer. Judicial ChoiceofLegal Doctrines' Working Paper#91-0134 No.50 BruceD. Smithand Anne P. Villamil. "Government Borrowingusing Bonds with Randomly Determined Returns: Welfare Improving Randomization in theContextofDeficit Finance" Working Paper#91-0148 No. 51 PabloT. SpillerandSantiago Urbiztondo. "InterestGroupsand theControl ofthe Bureaucracy: An Agency Perspectiveon the Administrative ProcedureAct" Working Paper#91-0152 No. 52 AldoRustichini and Anne P. Villamil. "Equilibrium PriceStickiness" Working Paper#91-0162 No.53 Jan K. Bruecknerand PabloT. Spiller Fares and Network 'Feed': Estimating EconomiesofTraffic DensityinAirline Hub-and-SpokeSystems'WorkingPaper #91-0180 No.54 ShaneGreenstein andGareyRamey"Intergenerational ProductCompetition and the Incentive to Innovate"Working Paper#92- 0106 No. 55 Charles D. Kolstad "RegulatingAStock Externality Under Uncertainty with Learning" Working Paper#92-0112 BEBR FACULTY WORKING PAPER NO. 92-01 12 Papers in the Political Economy of Institutions Series No. 55 College of Commerce and Business Administration University of Illinois at Urbana-Champaign March 1992 Regulating a Stock Externality Under Uncertainty with Learning Charles D. Kolstad Department of Economics Digitized by the Internet Archive in 2012 with funding from University of Illinois Urbana-Champaign http://www.archive.org/details/regulatingstocke92112kols DRAFT 2/92 REGULATING A STOCK EXTERNALITY UNDER UNCERTAINTY WITH LEARNING Charles D. Kolstad' ABSTRACT This paper concerns the problem ofefficiently regulating a stock externality (ie, emissions are regulated but the stock of the externality causes the damage) when uncertainty exists and learning is taking place about the nature of the externality. The tension is between substantial controls on pollutionwhen little is known about it versus waiting for more information before instituting controls. Acting soon reduces potential adverse effects; waiting will be advantageous ex post if the problem turns out to be less serious than expected. The case considered here is uncertainty in how the A pollution stock affects utility. three-period model is used to examine the question. 'institute for Environmental Studies and Department of Economics, University of Illinois, 1101 W. Peabody, Room 352, Urbana, Illinois 61801 and Department of Economics, University of California, Santa Barbara. Research supported by a grant from the Research Board of the University of Illinois and by NSF Grant SES-91-10325. The paper has benefitted from discussions with Charles Kahn and Henry van Egteren and from comments by Geir Asheim, Robert Deacon and seminar participants at the University of Illinois, the Norwegian School of Economics and CORE. An earlier version of this paper was presented at the 1992 ASSA meetings in New Orleans and the 1991 EAERE meeting in Stockholm.