International Pollution Control: Cooperative versus Noncooperative Strategies

International pollution control involving two neighboring countries is modeled as a simple two-player dynamic game. Each country produces a good that is consumed by domestic households. Production of each consumption good results in emissions of pollutants. Households in each country derive utility from the consumption of the domestically produced good but incur costs through the total stock of pollution (stock externality). In this setting we characterize cooperative as well as noncooperative pollution control strategies of the governments of the two countries that maximize the discounted stream of net benefits of a representative consumer. It turns out that when the governments are restricted to use linear strategies noncooperative behavior results in overall losses for both countries. If, on the contrary, governments use nonlinear Markov-perfect strategies and the discount rate is small enough a Pareto-efficient steady-state pollution stock can be supported as a differentiable subgame-perfect equilibrium. Thus, the emergence of first-best solutions (cooperative outcomes) does not require any institutional arrangements (threats, retaliation, etc.) but can be brought about through the use of nonlinear Markov-perfect equilibrium strategies.