Rule of law and policy-induced environmental technology adoption
Davide Infante
Associate Professor of Political Economy
Department of Economics and Statistics, University of Calabria, 87036 Campus di
Arcavacata di Rende (Cosenza) – Italy; tel: 0039 0984 492460;
fax: 0039 0984 492421; e-mail: [email protected].
Janna Smirnova
Postdoctoral Research Fellow in Political Economy
Department of Economics and Statistics, University of Calabria, 87036 Campus di
Arcavacata di Rende (Cosenza) – Italy; tel: 0039 0984 492444;
fax: 0039 0984 492421; e-mail: [email protected].
Address for manuscript correspondence: Prof. Davide Infante, Department of
Economics and Statistics, University of Calabria, 87036 Campus di Arcavacata di
Rende (Cosenza) – Italy; tel: 0039 0984 492460; fax: 0039 0984 492421;
e-mail: [email protected].
1
Rule of law and policy-induced environmental technology adoption
Abstract
The implementation of environmental technologies almost always complies
with regulation that is interdependent with the strength of the rule of law. We develop
a model demonstrating that when the rule of law is reinforced, pollution abatement
standard is more efficiently established and leads to the more successful adoption of
environmentally friendly technologies. We show that a more stringent rule of law
contributes to the achievement of second best allocation with less resource drainage
caused by rent-seeking and with lower costs of regulatory intervention. The model
sheds new light on implementation of environmental policies in a reinforcing
institutional context of developing economies.
JEL classification: H11; H23; P20.
Key Words: Rule of law; Pollution; Environmental technologies; Rent-seeking
Running Title: Rule of law and environmental technology
2
1. Introduction
Policy and institutional quality are highly interdependent: a strong
institutional environment is the result of successfully implemented policies, while
effective policies are grounded in high-quality institutions. Understanding the nature
of this relationship is crucial for economic development, particularly for societies
involved in significant social and economic changes, such as transition and
developing economies characterized by economic instability and a weak institutional
environment. In such contexts, institutions and policies undergo continuous changes,
which in turn influence the policy-institution equilibrium.
To analyse the relationship between institutions and policies we have
developed a model that focuses on the rule of law since it is one of the most
important institutions determining the implementation and outcome of economic
policy. A tangible example where the quality of the rule of law plays a crucial role is
that involving the adoption of environmentally friendly technologies. In fact,
environmental issues represent an ideal context for studying the interdependence
between institutions and policies for two reasons. The first is the fact that
environmental sustainability is a real and current international concern. Secondly,
environmental controls (Lovely and Popp 2008) almost always comply with
regulation, thus providing a context to model the interaction between institution
strength and success of regulatory policy (environmental policies are reviewed by
Jaffe et al. 2002 and Requate 2005).
3
While it is recognized that a complex interdependent relation exists between
the quality of institutions and the functionality of environmental policies, to our
knowledge there has been little theoretical work investigating this nexus. Our model
takes a step in this direction and examines how the stringency of the rule of law,
influences whether regulator policies are successfully implemented. In particular, we
demonstrate that reinforcing the rule of law not only increases the adoption of
environmentally friendly technologies, but also improves the implementation of
pollution abatement standards. More stringent rule of law leads to better allocation of
resources and thus increases social welfare.
2. Theoretical background
Among other crucial institutions, that of the rule of law has been captured
through both empirical and theoretical studies (for the discussion see Haggard and
Tiede 2011). In most of the cases, the rule of law is measured through the protection
of property rights (Acemoglu and Johnson 1993, Shleifer and Vishny 1994;
Acemoglu and Verdier 1998, Grossman 2001, Gradstein 2004, Donnelly 2006). Some
authors consider the rule of law to be reflected in other contexts. For example,
Cervellati et al. (2008b) interpreted the rule of law as the presence of social contracts
that delimit the conflicts society. Donnelly (2006) gave another plausible definition of
the rule of law describing it as the legitimacy by which the state provides security for
its citizens. This vision is close to Paavola’s (2007) who underlines that legitimacy
4
must rest on procedural justice. Another approach considers the importance of legal
origins as the fundamentals of the rule of law (Acemoglu et al. 2001, Beck et al.
2003, Djankov et al 2003). Finally, others (Licht et al. 2007, Cervellati 2008a,
Norman 2009) have captured the rule of law using the well-known composite index
provided by Kaufmann et al. (2007) or other indexes (Butkiewicz et al. 2006).
The above contributions underline the importance of the enforcement of the
rule of law for determining successful economic policies. Following this reasoning,
the rule of law should play a crucial role also in implementation of environmental
regulations. According to Vatn (2005 and 2010), the institutional frame is
fundamental for environmental policy, given that it influences agents behaviour
which becomes especially important in the presence of externalities typically present
in environmental issues.
A constantly increasing body of literature has provided evidence on the
importance of institutions in environmental issues. Among empirical studies, much
attention has been dedicated to the impact of corruption on environmental issues
(Damania et al. 2003, Cole 2007, Leitão 2010). Corruption is demonstrated to have a
negative effect on environmental quality, undermining the working of environmental
policies, especially in developing economies. Institutions such as political liberties,
civil rights and democracy (Torras and Boyce 1998, Bhattarai and Hammig 2001,
Frankel and Rose 2002) are proved to contribute positively on pollution abatement.
Secure property rights are also important for improvement of environmental quality
5
(Culas 2007). In turn, legal protection is demonstrated to have negative relationship
with pollution levels (Di Vita 2009).
At the theoretical level, Brock and Taylor (2003), Dinda (2004) and Yandle et al.
(2004) discuss the influence of institutions on environmental quality and demonstrate
the importance of institutional strength in pollution abatement. Weisbuch (2000)
analyses the influence of institutions in decision making process regarding
environmental issues. Paavola (2007) discusses the incidence of property rights on
the use of environmental resources. Damania et al. (2003), Fredriksson and Svensson
(2003) and Wilson and Damania (2005) demonstrate the negative effects of
corruption on the stringency of environmental policy.
Although rule of law is one of the important institutions for environmental
policies, as discussed by Galeotti (2007), it has not been much considered. Few works
(Panayotou 1997, Bhattarai and Hammig 2001) incorporate the rule of law by
utilising composed indexes and demonstrate that institutional improvement
significantly reduce the degree of pollution.
Our work differs from the previous studies on environment-institutions
relationship by analysing theoretically the rule of law in environmental issues through
investigating on regulator policy that promotes the adoption of environmentally
friendly technologies. The model also adds the analysis of the importance of
institutions to a growing theoretical literature on the interaction between
environmental policy and technological change (among recent works are Kerr and
6
Newell 2003, Goel and Hsieh 2006, Lovely and Popp 2008 and the review elaborated
by Jaffe at al. 2002).
Our theoretical framework is related to the model presented by Acemoglu and
Verdier (2000) who explored the issue of new technology adoption in the presence of
corruption. This framework has been further developed by Infante and Smirnova
(2009) by incorporating into the model an institutional parameter to investigate on the
importance of institutional enforcement. The present work extends the above two
models to investigate the relationship between the adoption of environmentally
friendly technologies and the stringency of the rule of law. To our knowledge, to
date, no model has yet explored this relationship.
3. Model
The model is based on stylized features of an economy in which agents can be
both entrepreneurs or inspectors. The entrepreneurs produce output with currently
available but an environmentally unfriendly technology. A regulator sets either fines
and subsidies to incentivise entrepreneurs into choosing the clean technology.
Inspectors monitor firms randomly to determine which should be subsidised or fined.
Although inspectors can be corrupt and seek bribes from a firm, there is the
possibility that the firm appeals to the court. The probability of appealing to court is
taken as a measure of the strength of the rule of law. The aim of the regulator is
therefore to implement a policy so to achieve a second-best allocation where all
7
entrepreneurs utilise the environmentally friendly technology, thereby neutralising
pollution.
The outcomes of the model are firstly obtained for a weak institutional
context. Thereafter, we assume that the rule of law is reinforced (section 3.5) and,
finally, revise the outcomes of the model to capture these changes.
3.1. Regulator
In a closed economy with a command control context, the entrepreneurs (n)
produce output (y) by utilizing a production process which relies on a polluting
technology. The benevolent regulator1 makes the decision to regulate the pollution
level (), providing incentives that encourage entrepreneurs to adopt an
environmentally friendly technology of cost c, where c £ y . To do this, the regulator
employs, choosing from among the entrepreneurs, some inspectors2, who must
enforce the regulation, offering these inspectors wage w. The total number of
entrepreneurs and inspectors is normalised to 1.
1
Environmental matters often involve solutions based on the central role of the
government which determines decisional rules, commands, controls and procedures
to observe when making environmental decisions (Boyer and Porrini 2001, Paavola
2007). The presence of benevolent government does not contradict the presence of
weak institutions, given that in this context the interests of the policy-maker are often
different from those who implement the policy.
2
The description of allocation of agents between inspectors and entrepreneurs is not
shown for the sake of simplicity. However, an example of such a mechanism can be
found in Infante and Smirnova (2010).
8
To incentivise the choice of the new technology, inspectors transfer subsidies
(s) to reward entrepreneurs who adopt the environmentally friendly technology (of
number m), and collect fines (f) to sanction entrepreneurs who continue to utilize a
polluting technology (of number n-m).
We assume that the regulator aims to obtain the complete abatement of
emissions, which requires that all of the entrepreneurs adopt the new technology3 (in
this case it would be n=m). Indeed, for the regulator, total neutralisation of external
harm is convenient only when the benefits from the complete abatement of emissions
offset the costs needed for abatement. Therefore, the regulator incentivises the
adoption of the environmentally friendly technology only in the case where
intervention increases social welfare. In other words, the decision to regulate is taken
only when the welfare level attainable through intervention is greater than that
without intervention. That is, W 2 ³ W1where:
W1 = y - a
(1)
W2 = (y - c)n
(2)
3
Inducing a radical change in technology is a reasonable assumption since
incremental technology change may not achieve environmental sustainability (Kemp
1997).
9
3.2. Entrepreneurs and inspectors
Since the adoption of the environmentally friendly technology is costly,
entrepreneurs adopt it only in the presence of regulatory stimuli. These stimuli are
expressed as environmental subsidies and fines. Both subsidies and fines are activated
only when monitoring is undertaken by the inspector, so that, subsidies and fines are
paid and obtained with a probability 1- n , and hence 0.5 £ n £1. Following
n
Acemoglu and Verdier (2000) this also means that an inspector can monitor only one
entrepreneur. To avoid the regulator supporting the entire social cost of pollution
abatement, it is assumed that subsidies are rationed, i.e. that not all of the adopters
receive subsidies, given that the total amount of environmental taxes should be equal
to environmental subsidies. Moreover, subsidies are taken in the form of tax offsets,
that are discounted from general revenue tax that both types of entrepreneurs pay.
The presence of general revenue tax guarantees the sustainability of regulator’s
budget4.
In such a rationed context subsidies and fines thus represent an ideal terrain
for inspectors’ rent-seeking activities (Bardhan 1997, Saha 2001). An inspector who
is self-interested would have quite a degree of freedom to practice corruption and, in
addition to the salary received as an inspector, may obtain a bribe (b), from both
entrepreneurs who do adopt the new technology and those who do not. The adopters
4
This amount of taxes is omitted in the model for the sake of simplicity.
10
may be extorted and be asked to pay a bribe to obtain their rightful subsidy, while
non-adopters may also be asked to pay a bribe so that the inspector falsely reports use
of the new technology. Obviously, in the latter case b £ f . The probability of
practicing rent-seeking is given by r.
3.3. Rule of law
The rule of law is inserted in the model following Donnelly (2006, p.37) who
states that, “When citizens can bring disputes concerning rights to court rather than
fight in the streets, the rule of law is enhanced”. We, therefore, define the rule of law
as the probability that an entrepreneur, who is the subject of extortion or corrupt
proposals, appeals to a court. This approach is close to that adopted by Rijckeghem
and Weder (2000), who, on the contrary, used an index of rule of law as a proxy of
the probability that corruption will be detected. Hence, we suppose that in the case
where an inspector seeks bribes, there is a certain probability (d) that the inspector is
reported. Assuming that the regulator may penalize the inspector and not the
entrepreneur for rent-seeking activities, in the event that corruption is reported by
entrepreneurs, the corrupt inspector will be fired, losing salary and other gains.
Our model considers the rule of law reinforced when the probability of being
reported increases in the range from zero to one. Therefore, the strength of the rule of
law and the degree to which society accepts rent-seeking activities becomes decisive
11
in whether individuals opt for corrupt practices. Where the rule of law is weak and
rent-seeking activities offer high returns, there is greater incentive to switch to rentseeking activities. By contrast, where the rule of law is strong and corruption is less
practicable, the payoff that an inspector receives is greater if s/he adheres to honest
practices.
3.4. Implementing the pollution abatement policy
3.4.1. Sequence of events
By introducing inspectors, the aim of the regulator is to achieve a second-best
equilibrium where all the entrepreneurs choose to utilize the environmentally friendly
technology to neutralise pollution and increase social welfare. To achieve this
equilibrium, the regulator utilises the following instruments: the inspectors’ wages,
and entrepreneurs’ subsidies and fines.
The sequence of events is traced through backward induction (see Figure 1).
At the first stage, the regulator calculates the second-best allocation of agents to
obtain n=m, by considering technological, budgetary, non-bankruptcy and corruption
constraints, also taking into account the following factors: a) the cost of adopting a
new technology; b) the output of entrepreneurs; c) the probability that inspectors
practice corruption and extortion; d) the level of bribes; e) the strength of rule of law.
At the following stage, on the basis of the second-best allocation of agents, the
12
abatement standard of external harm, (  st ), is determined by comparing welfare
functions (1) and (2). This abatement standard or, in other words, the threshold level
of pollution, determines whether the regulator undertakes action. In fact, the regulator
decides to incentivise the adoption of the environmentally friendly technology if the
actual level of pollution is greater than the obtained abatement standard a ³ a st .
Once the decision to intervene is taken, the regulator establishes the levels of
subsidies, fines and inspectors’ wages so that the composition of these variables
would indeed lead to the allocation of agents n=m to neutralize external harm ( a =0).
This mechanism of regulator intervention is represented in Figure 1.
Fig. 1. The pollution abatement strategy: flows and outcomes.
13
3.4.2. Second-best allocation and the abatement standard
In this section we describe the steps involved for establishing the
aforementioned regulator’s policy. In order to define the second-best allocation of
entrepreneurs and inspectors, the regulator must first consider the technological
constraint:
y - a (n - m) - c +
1- n 1- n
1- n
1- n
srb ³ y - (1- r) f
- rb
,
n
n
n
n
(3)
where on the left side there are the gains of entrepreneurs who adopt the new
technology, while on the right side there are the gains obtained by entrepreneurs who
continue to use the polluting technology.
The first three terms of inequality (3) define the output, minus the loss (in the
form of pollution produced by entrepreneurs who continue to use the old technology),
and minus the cost of adopting the environmentally friendly technology. The latter
two terms on the left side refer to the gains obtained through subsidy which is
received, given the probability of being monitored, and losses due to a bribe, given
the probability of being monitored by a corrupt inspector. On the right side, the first
term defines the entrepreneur’s output and the second refers to losses due to the
payment of fines, if monitored by an honest inspector. The last term defines losses
due to a bribe, given the probability of being monitored by a dishonest inspector.
Obviously, the regulator establishes that the gains of entrepreneurs who adopt the
new technology are greater than of those who do not adopt it.
14
At the same time, the regulator should consider that fines paid by
entrepreneurs who continue to utilize the environmentally unfriendly technology
should not exceed the output produced by these entrepreneurs, so the non-bankruptcy
constraint has the following form:
f £y
(4)
In order to minimize rent-seeking activities, the regulator sets the gains of the
honest inspector to be greater than that of the corrupt inspector. The gains of the
honest inspector are given by the wage alone, w. The gains of the dishonest inspector
is the sum of her wage plus the benefits from receiving a bribe, minus the wage lost
given the probability that illegal actions are reported, so that:
w ³ w + rb - rdw
(5)
Finally, the regulator must also consider the sustainability of the budget, so
that the revenues of the regulator are greater than the expenditures:
1- n
1- n
ms
(1- r)(n - m) f ³ (1- n)w - rd(1- n)w +
n
n
(6)
The budgetary revenues, expressed on the left, correspond to the amount of fines
collected from the entrepreneurs who do not adopt the environmentally friendly
technology, given the probability of being monitored by honest inspectors. The
budgetary expenditures, expressed on the right, corresponds to the wages paid to
inspectors, minus wages that re-enter the budget when dishonest inspectors are
reported, plus the amount of subsidies released for the adoption of the new
technology.
15
The final requirement is the complete neutralization of external harm,
prompting the regulator to establish that all entrepreneurs should adopt the new
technology. i.e.:
n=m
(7)
In order to find the second-best allocation of entrepreneurs, the regulator
solves the system of inequalities from (3) to (6). To do this, the inequality (3) is
simplified, assuming that y=f. In the next step, both sides of (3) are multiplied by m.
The obtained inequality is then summed to (6), which gives:
1- n
1- n
(1- r)(n - m)y - m(a (n - m) + c) ³ w(1- n)(1- rd) (1- r) my (8)
n
n
To proceed, the inequality (5) is simplified and both sides are multiplied for
(1- n)(1- rd) ³ 0. The obtained inequality is summed to (8), which gives:
1- n
b 1- n
(1- r)(n - m)y - m(a (n - m) + c) ³ (1- n)(1- rd) (1- r) my (9)
n
d
n
Finally, by substituting n=m in inequality (9), the second-best allocation of
entrepreneurs and inspectors is thus given by:
mº
d(y - yr + br) - b
d(y - yr + br) - b + dc
(10)
As (10) demonstrates, the role of the rule of law is crucial at this stage, since,
when defining the number of entrepreneurs, the regulator must consider the
probability (d) that some entrepreneurs may report rent-seeking inspectors. In such a
case, the equilibrium of the second-best allocation of agents and, as shown hereafter,
the abatement standard, both depend on the strength of rule of law.
16
Subsequently, the regulator by comparing the welfare attained in the case of
intervention (1) or in the absence of intervention (2) and, considering allocation (10),
obtains the following abatement standard:
a st ³ c
d(y - yr + br) - b + dy
d(y - yr + br) - b + dc
(11)
As discussed in section 3.4.1, the regulator applies the pollution abatement
policy only when the actual level of pollution exceeds its pre-established threshold
level:
a ³ a st
(12)
Therefore, the regulator is only prompted to enact environmental-protection
policies when current levels of pollution exceed the established abatement standard
a st . In fact, the greater the value of a st , the higher the amount of actual pollution
“needed” to prompt environmental-protection intervention. At lower levels of a st the
regulator policy is enacted even for low levels of pollution, thus increasing welfare.
As such, if inequality (12) does not hold, the regulator does not enact interventions
since the benefits of pollution abatement are not large enough to offset necessary
costs.
17
3.5. Reinforcement of the rule of law
The impact of the rule of law becomes evident upon differentiating (10) and
(11) with respect to the parameter d. Given that
¶m
³ 0, for defined parameters
¶d
value, improving the quality of rule of law would encourage entrepreneurs to report
corruption and distortion in an effort to protect their rights. As a result, under a
stringent rule of law5, more entrepreneurs would choose to adopt the environmentally
friendly technology. In fact, when the rule of law is enforced, the regulator may
subsequently need to introduce fewer inspectors, output, thus, reducing the welfare
cost of intervention. Therefore, in a context where the rule of law is functional and
strong, more entrepreneurs are willing to adopt environmentally friendly
technologies, which in turn has a positive impact on welfare, as demonstrated by
equation (2). It can also be noted from equation (10) that when the cost of the
technology decreases, the number of entrepreneurs who adopt the new technology
increases, incentivising the diffusion of the environmentally friendly technology.
Interestingly, however, condition (11) shows that there is an inverse relation
between the strength of the rule of law and the abatement standard:
¶a st
£ 0, for the
¶d
defined parameters value. Therefore, the higher the quality of the institution, the
5
Given that 1/2 £ m £1 and 0 £ d £1, the minimum of d corresponds to m=1/2 and is
given by
d=
0,5b
³0
0,5(yr - c - y) + y - yr + br
,
while the maximum is d=1.
18
lower the abatement standard, which indicates that, upon intervention, external harm
is neutralized more effectively. Inequality (11) also illustrates the negative effect of
illegal rent-seeking on pollution, which is high where there is room for corruption,
leading to negligible improvements in pollution abatement.
Fig. 2. Reinforcement of the rule of law and its impact on abatement standard, social
welfare and entrepreneurs’ allocation.
To illustrate the above, Figure 2 shows6 the effects of different rule of law
parameter values on the allocation of entrepreneurs (m), welfare ( W 2) and the
6
Coefficients used in Figure 2 and Figure 3 are normalised to one and are the
following: y=1, c=0.5, r=0.1, b=0.1, w=0.8, m=0.55.
19
abatement standard ( a st ). According to our findings, when the rule of law parameter
is raised, there is an increase in the number of environmental friendly technology
adopters and the level of welfare, and there is a decrease in the abatement standard of
pollution. Thus, the numerical simulations show that the reinforcement of the rule of
law positively influences the regulator policy of pollution abatement.
The regulator instruments are considered at the last stage when level of
subsidies (s), fines (f) and wages (w) are defined. The simulation in Figure 3
evaluates these policy instruments and examines their changes obtainable under
different rule of law parameters. Both fines and subsidies (recall that subsidies take
the form of tax offset) decrease with increasingly stronger rule of law. This is
because, in the presence of weak institutions where the state cannot guarantee that all
members respect the law, more incentives are needed to prompt entrepreneurs to
switch to the environmentally friendly technology. The “carrot” in the form of
subsidies and the “stick” in the form of fines have higher values under a persistently
weak rule of law than under a situation where the rule of law is reinforced so that
agents are encouraged to take their cases to court.
As for the relationship between the practice of rent-seeking and the strength of
the rule of law, Figure 3 shows that inspectors’ wages decrease when the probability
of being reported for corruption or extortion increases: the more likely entrepreneurs
will report illegal practices to the court, the less the amount of wage needed for an
inspector. In fact, where the quality of the rule of law is weak, more incentives are
20
needed to ensure that an inspector is not tempted to engage in rent-seeking activities,
making it necessary to maintain relatively high wages so to prevent corruption.
Fig. 3. Reinforcement of the rule of law and its impact on the regulator policy.
Equation (13), obtained by considering together (5) and (10) confirms this
relationship:
w º y + r(b - y) + c
where
y -a
c -a
(13)
¶w
£ 0, for the defined parameters value. There is therefore a negative
¶r
relationship between wages and the probability of being involved in corruption,
21
confirming empirical findings which show that higher rates of corruption are found in
countries where the wages of the public sector are low (Bardhan 1997).
4. Conclusions
In this paper, we have developed a theoretical model that demonstrates that
the successful adoption of environmentally friendly technologies is dependent upon
the degree to which rule of law is enforced. We measure the rule of law as the
probability that entrepreneurs experiencing extortion or corruption appeal to the
court. A more stringent rule of law thus represents a tool for achieving the secondbest resources allocation when a regulator enacts an environmental policy. As such, a
strong rule of law creates barriers against losses caused by rent-seeking activities
which in the context of environmental protection, would lead to dire consequences
for the environment.
Although the model does make some strict assumptions, our findings
contribute to a better understanding of the links between institutions and the
environment. The results of our model confirm empirical findings regarding how
conditions of the institutional context influence economic performance. In particular,
the model shows that reinforcing the rule of law actually leads to an enlargement of
the production sector opting for environmentally friendly technologies, increasing
social welfare. We also demonstrate that under a stringent rule of law, the
establishment of a pollution abatement standard is more efficient and leads to the
22
neutralization of even low levels of pollution. Moreover, with a reinforced rule of
law, external harm may be neutralised with lower costs of regulator intervention not
only because rent-seeking activities are discouraged, but also because fewer
inspectors are needed to enforce policies. We argue that where the rule of law is
weak, for environmentally friendly technologies to be adopted successfully, it is
necessary to redesign optimal regulator policies attainable through incentives such as
inspector wages, subsidies and fines so as to offset illegal rent-seeking activities.
Considering both the global move towards environmental technologies plus
the fact that Countries with weak institutions, which rely heavily on polluting
technologies, are under international pressure to the same, for the effective
environmental policies it is crucial to pay more attention to the enforcement of the
rule of law. The model thus represents a contribution to encouraging transition and
developing economies to implement policies that strength the environmentinstitutions relationship.
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