We examined in this chapter a particular form of asymmetric information where a firm knows its emissions abatement costs but the regulator does not. The regulator must ask firms to reveal abatement costs in order to select an efficient emission reduction target. We demonstrated that where a firm expects the EPA to use a marketable permit system, it may be in the interest of firms to exaggerate their marginal abatement costs (MC). In contrast, where a firm expects the EPA to use an emissions tax, firms have an incentive to understate their abatement costs.

Suppose that the regulator committed itself to randomly selecting either a fee or a marketable permit system (each with a probability of onehalf), but only after it received cost information from firms. Would this system generate truthful reporting by firms?