Journal

of Public Economics

34 (1987) 1944.

North-Holland

PERFORMANCE
VERSUS DESIGN STANDARDS
IN THE REGULATION
OF POLLUTION
David

BESANKO*

School of Business, Indiana University, Bloomington, IN 47405, USA

Received

May 1986, revised version

received

May 1987

This paper presents a model of pollution regulation

in an oligopolistic
market. Two forms of
regulation
are considered: performance
standards
which regulate pollution directly by an upper
limit on emissions, and design standards
which regulate pollution
indirectly
by a minimum
usage requirement
of an emissions control input. Equilibria
under each regulatory
regime are
characterized.
A welfare analysis reveals that performance
standards
are preferred to design
standards
if the objective is minimization
of emissions plus pollution damage costs. However,
the comparison
is indeterminate
if the regulators
objective is total surplus less pollution
damage. An equivalence
between emissions taxes and performance
standards
is established,
so
the above welfare comparisons
also apply to emissions taxes versus design standards.

1. Introduction
A common
form of regulation
in the presence of externalities
or information
problems
is standard-setting.
Standard-setting
is widely used in
environmental
regulation,
regulation
of product and occupational
safety, and
regulation of product efficacy and durability.
An important
issue in devising a standard is whether the standard should
specify performance
goals (a performance
standard)
or should specify the
procedures
used to meet the performance
goal (a design standard).
In the
context of air quality regulation, a performance
standard would place a limit
on a factorys emission of sulfur dioxide per million parts of air, while a
design standard would specify the minimum efficiency of a stack gas scrubber
designed to reduce SO, emissions.
Although a performance
standard and a design standard may be directed
toward the same goal (cleaner air, fewer workplace accidents), their economic
consequences
may be quite different. Breyer (1982) notes that although
design standards are easier to enforce than performance
standards:
*This work was begun while 1 was visiting the Economics
Research
Group
at Bell
Communications
in 1985. I would like to thank David Baron, David D. Martin, Martin Perry,
and David Sappington
for helpful discussions
on this paper, and two referees for their useful
comments and suggestions.

OQ47-2727/87/$3.50

1987, Elsevier Science Publishers

B.V. (North-Holland)

20

D. Besanko, Performance vs. design standards

. . . design standards limit the firms flexibility. A firm that finds a

cheaper or more effective way of achieving the regulations objective
must undertake the heavy burden of forcing a change in the standard
before it can use its new method. For the same reason, a design
standard tends to freeze existing technology and to favor those firms
already equipped with that technology over potentially innovative new
competitors.
A performance standard permits flexibility and change. It is directly
addressed to the problem that must be solved. And since the agency
must, in any event, consider the comparative performance of different
machines in order to write a design standard, it may be easy for the
agency to write its standard directly in terms of performance goals such
as cleaner air or fewer injuries [Breyer (1982, p. 105)].

The purpose of this paper is to analyze the economic consequences of

performance and design standards in a stylized model of regulation. To be
concrete, the model is described in the context of pollution regulation,
though the model could apply to occupational safety and health regulation
or product safety with the appropriate redesignation of variables. The model
focuses on the regulation of an oligopolistic industry consisting of identical
firms each of which emits pollution. The government can set either a
performance standard or a design standard. The industry equilibrium under
each regulatory regime is analyzed, and the economic consequences of each
type of standard are discussed. As the comments of Breyer suggest, we find
that a performance standard allows the regulator to achieve a given pollution
target at a lower cost of emissions control than does a design standard. It is
therefore easy to show that a regulator who is concerned with minimizing
the costs of emissions control plus pollution damage (subject to a minimum
profit constraint) will prefer an optimally chosen performance standard to an
optimally chosen design standard. However, there is a cost to the efficiency
gain from a performance standard: for any given level of pollution, a
performance standard results in a smaller aggregate industry output than
does a design standard. If the regulators objective is social welfare maximization there may be circumstances under which the regulator will prefer an
optimally chosen design standard to an optimally chosen performance
standard. It has been argued by some authors [e.g. Roberts and Farrell
(1978)] that environmental regulators care about other factors besides
emissions control and pollution damage costs (e.g. local employment impacts
of environmental regulations). To the extent that social welfare maximization
adequately represents regulatory objectives in pollution control, our analysis
provides a positive rationale (that does not rest on differences in enforcement
costs) why environmental regulators might prefer design standards to performance standards.
Models of pollution standards and optimal pollution standards have been

D. Besanko, Performance vs. design standards

21

studied by many authors including

Kwerel (1977), Spence and Weitzman
(1978), Dasgupta,
Hammond
and Maskin
(1979), Dasgupta
(1982), and
Baron (1985a, 1985b). Our paper differs from these papers in its emphasis
upon the comparative
advantages
of different types of standards. In addition,
the focus of many of these papers is on the impact of uncertainty
or
asymmetric information
on optimal pollution
regulation.
This paper demonstrates that even under certainty
and symmetric
information
there are
nontrivial
tradeoffs
to be considered
in the choice of the method
of
regulating pollution. The paper most closely related to ours is a recent study
by Farber and Martin (1986) of the relationship
between market structure
and pollution
control
activity.
Farber
and Martins
paper focuses on
performance
standards
in a setting in which the regulator can monitor only
imperfectly.
A principal
theoretical
finding of their study is that under
plausible circumstances
pollution
control activity by a firm will decrease as
rivalry in the market increases. The empirical
analysis
presented
by the
authors supports this result.
Our paper is organized
in the following
manner.
Section 2 gives an
overview of the model. Section 3 characterizes
the industry equilibrium
under
a performance
standard, and section 4 characterizes
the industry equilibrium
under a design standard.
Section 5 compares the welfare effects of performance standards
and design standards.
Section 6 elaborates
on the analysis
of section 5 in the context of a specific example. Section 7 contains
a
discussion of the issue of pollution taxes versus standards. Section 8 discusses
the limitations
and possible extensions
of the model. Section 9 summarizes
and concludes.
2. Overview of the model
2.1. The regulated

industry

We consider an oligopoly consisting of a fixed number n of identical firms

where 1 sn< co. The output xi of a typical firm i in conjunction
with a
quantity ei of a composite emissions-control
input (hereafter e.c.i.) determines
a quantity qi of pollution emitted by that firm according to:
4i

ftxi,

(1)

eih

where f is a twice-continuously
differentiable
quasi-convex
function,
with
f, >O and f, ~0. The function f(.) is a reduced-form
pollution
production
function. To see how this reduced form is derived, suppose that each firm in
the industry
manufactures
a joint product (x,q) according
to production
functions:

x =A+, 4,

q = &, 4,

D. Besanko, Performance us. design standards

22

where z E R is the vector of productive inputs.

(1) we assume that h(.) has the specific form:

To develop

the specification

in

h(z,4 = f(&, 44,

where f(.) is the function
defined in (1). This specification
assumes that
pollution
is a direct byproduct
of a firms output. An example where this
specification
is plausible
would be the case of a producer
of electrical
capacitors
that have PCBs as an insulating
fluid. In the process of manufacturing capacitors, a certain proportion
of defectives are produced, and the
disposal of these defectives creates pollution.
Consequently,
the amount
of
pollution
will be an increasing
function
of the number
of nondefective
capacitors produced and sold.
The assumption
that f(.) is quasi-convex
in (x,e) implies that the marginal
rate of substitution
of output for e.c.i. is an increasing
function of output.
Thus, the more output the firm produces, the greater is the required increase
in the e.c.i. in order to keep pollution constant.
The cost function of a typical firm i takes the form:

c(eJxi+ Neil,
where c(e,) is the marginal
cost of output, and k(ei) is the fixed cost of
installing e, units of the e.c.i. The marginal cost function c(.) is assumed to be
twice-continuously
differentiable,
nondecreasing
and (weakly) convex in e; i.e.
~20, ~20. The emissions control cost function k(.) is assumed to be twicecontinuously
differentiable,
increasing,
and (weakly) convex in e; i.e. k >O;
k 2 0. In addition, k(0) = 0.
Firms are assumed
to behave as Cournot
competitors
and thus set
outputs. The profit of a typical firm i is given by:

Another set of assumptions

applicable to air pollution will also generate the specification
in
(1). Suppose z denotes the tons of coal used by a manufacturer
and let x=g(z) denote a firms
production
function. Let q=s( 1-e)z, where e represents the percentage
of sulfur removed by a
flue gas desulfurization
system (scrubber), and s is the sulfur content of a ton of coal. Solving
out z one obtains:

where g-l(.) is the inverse of g.

Under the interpretation
of the underlying
c(eJx, = min w

technology

discussed

above,

2;

s.t. x,=&,eJ,
where w is a vector of input prices. We are thus implicitly
assuming
that g is linearly
homogeneous
in a. The assumption
that ~20 would follow if g,sO,
i.e. if the e.c.i. had a
nonpositive marginal product of output.

23

D. Besanko, Performance us. design standards

where P(X) denotes the industry

inverse demand
function,
and X=cxj
denotes industry
output. The inverse demand function is assumed to be a
twice-continuously
differentiable
decreasing function of X over the interval
[0,X], where X-C cc is such that P(X)=O.
We also assume that for any
X5X,
P(X)X + P(X) 50. This assumption
will be satisfied if the inverse
demand is concave in X or not too convex.3 The role of this assumption
and the assumption
that P(X) goes to zero at a finite X is to ensure the
existence of an industry equilibrium.
2.2. The regulatory constraints
The regulator is presumed able to specify either a performance standard (a
maximum allowed pollution per firm) or a design standard (a minimum level
of the e.c.i. per firm). Under a performance
standard
each firm faces a
regulatory constraint
of the form:
fCxi,

5 qp,

where qp is the maximum level of pollution allowed per firm.4 Each firm then
chooses output xi and a quantity e; of e.c.i. to satisfy the constraint.
Under a design standard, the regulatory
constraint
for each firm is of the
form:
ei 2 e,.

Each firm is then free to select its output.

The chief administrative
difference between

a performance

standard

and a

31t is straightforward
to prove that the assumption
that P(X)X+P(X)
50 is a sufficient
condition
for a firms revenue function
P(x+X,)x
to be concave in x for X~E [O, X] and
x E [0, X]. The concavity of the tirms revenue function is used in the proof of the existence of an
industry equilibrium.
(See footnote 7 below.) The assumption
that P(X)X+P(X)<O
is also a
sufficient condition for a firms Cournot reaction function x(X,) to be decreasing in the output
X, of all other firms in the industry.
4The performance
standard
in this model can be thought of as arising in one of two ways.
First, we can think of the regulator as imposing a maximum level of pollution on each firm by
fiat. Alternatively,
the upper limit qp can be thought
of as arising because each firm in the
industry has purchased
q,, marketable rights to pollute. For this second interpretation
to be
convincing,
we need to include in our model the decisions by firms to trade these marketable
rights among themselves and the determination
of an equilibrium
price of rights. However, in
our setting a detailed theoretical
treatment
of these issues is unnecessary.
To see this, suppose
that before the product market opens each firm in the industry is awarded a certain number of
marketable
rights (which may or may not equal qP but which add up to nq,). In an equilibrium
in marketable
rights, firms will trade the rights among themselves until the marginal benefit of a
right is equated across all firms (where the calculation
of marginal
benefit takes into account
profits in the subsequent
product
market
equilibrium).
Since all firms are symmetric,
by
assumption,
marginal benefits will be equated when each firm acquires an equal number qp of
the rights.

24

D. Besanko, Performance us. design standards

design standard
is that under a performance
standard
the regulator would
monitor the actual pollution emitted by a firm while under a design standard
the regulator
would monitor
the efficiency of the system the firm puts in
place to control
emissions.
For example,
suppose
a firm manufactures
railroad
ties and generates
hazardous
creosote waste as a byproduct.
A
performance
standard
would involve monitoring
the quantity
of creosote
waste generated by the firm while a design standard would involve monitoring the procedures followed by the firm to dispose of or store the hazardous
creosote waste. A firm may do a poor job of disposing of the waste (low e)
but may not generate much pollution because its output x is low. Intuitively,
a performance
standard gives a firm more freedom because the standard can
be met either by increasing the efficiency of the emissions-control
system or
by cutting back on output, whereas a design standard can only be met by
increasing
the efficiency of the emissions-control
system. In practice, the
distinction
between a performance
standard
and a design standard may be
quite subtle. Consider the example of a manufacturer
of electrical capacitors
that uses PCBs as an insulating
fluid. A design standard
might be a
specification
of procedures for disposing of defective capacitors that contain
PCBs. To monitor
compliance,
the regulator
might send an official to
observe whether these disposal procedures
are being followed. However, if
this type of monitoring
is costly, the regulator
may end up monitoring
compliance
by measuring
the amount
of PCBs in the soil where the firm
dumps its wastes. If the latter enforcement
procedure is used, the effective
standard
is a performance
standard
because compliance
depends on the
amount of pollution created by the firm, even though the nominal standard
is a design standard.
2.3. Welfare analysis and regulatory objectives
In analyzing
optimal performance
and design standards,
two regulatory
objectives will be considered.
The first objective is social welfare maximization (SWM) subject to a minimum
profit constraint.
Social welfare is
defined as the sum of consumers
and producers surplus minus the social
costs B(cqj) of pollution damage. The social cost function is assumed to be
increasing
and (weakly) convex, i.e. B>O, and B 20. Under SWM the
regulators objective can be written as:

v(X) -C

c(ej)Xj-1

k(ej)

-B(C 4j)3

where V(X) =jtP(t)dt

is the gross willingness to pay for the industry output.
The second regulatory objective studied is cost minimization
(CM) subject
to a minimum profit constraint.
The regulators objective function under CM
o f emissions control and pollution costs.
is the sum c k(ej)+B(xqj)

D. Besanko, Performance us. design standards

25

The regulator is assumed to have full information about the technological,

cost, and demand conditions. The regulator will be assumed to precommit to
a standard, and the firms will then respond and reach an equilibrium in the
the appropriate
game-theoretic
product market. With precommitment
structure is to treat the regulator as a Stackelberg leader who takes into
account how the standard affects the equilibrium in the product market.5

3. Industry equilibrium under a performance standard

Under a performance
be stated as?

standard a firms profit-maximization

problem can

max P(X)x - c(e)x - k(e),

s.t.

(2)

x 2 0.

Given our assumption on technology and demand, an application of

Friedmans (1977) Theorem 7.8 can be used to prove that an equilibrium
exists. Throughout the analysis we will assume that the equilibrium is
symmetric and we will focus on the case in which the regulatory constraint
(2) is binding and in which industry output Xp and the quantity ep of the
e.c.i. are positive. The conditions characterizing such an equilibrium are:
P(Xp)xp+ P(X) - c(e4 =
- c(eP)xP- k(eP)=

Afx(xp,eP),

Af,(x, eP),

(3)
(4)

The precommitment
assumption
is important.
In the absence of precommitment
an alternative formulation
would be to have the tirms and the regulator
move simultaneously
and to
analyze the Nash equilibrium
in outputs and a standard.
To see the implications
of this setup,
notice that in our model the regulators objective function under either SWM or CM does not
depend directly on the standard (either qP or e,). Instead, it depends on the choices made by the
firms (x, e, and q). This implies that there will be many Nash equilibria in the game in which the
firms and regulator move simultaneously.
One Nash equilibrium
is where each firm conjectures
that the regulator will set a standard
which is sufficiently lax so that the unregulated
Cournot
output and a zero level of e.c.i. are feasible. Given such a conjecture each firm will produce its
unregulated
Cournot output. In turn, if the regulator conjectures that the firms will produce this
output and choose zero e.c.i., the regulator (being indifferent across standards,
given conjectures
about output, e.c.i., and pollution levels) will have no incentive not to choose the lax standard.
6Where there is no ambiguity, the subscript designating
a firm will be dropped.
A proof of the existence of an equilibrium can be found in Besanko (1987).

D. Besanko, Performance OS.design standards

26

fbP, e)= qp,

(5)

where xP=XPn- , and A>0 is the Lagrange

multiplier
for the regulatory
constraint (2).
Analysis of the first-order conditions
yields the following result about the
equilibrium
industry output under a performance
standard.
Proposition

1.

Under

a performance

Xp is less than the unregulated

ProqjI

emissions

standard,

Cournot

the industry equilibrium

industry equilibrium

output

output Xc.

In the absence of regulation,

each firm would spend nothing
control, and the industry equilibrium
output Xc would satisfy:

on

p(XC)xC+P(XC)-c(O)=O,

(6)

where xC=XCnm.

Because c(e) zc(O), (6) and (3) imply:

p(XP)xP+ P(X) > p(XC)xC+

P(XC).

The assumption
that P(X)X+P(X)sO
P(X)Xn-
+ P(X) is strictly decreasing

(7)

can be shown to imply that

in X.8 Thus, (7) implies Xp<Xc.
Q.E.D.

The result holds for two reasons. First, the regulatory

constraint
induces
each firm to use a positive quantity
of the e.c.i. which raises marginal
production
cost. Second, the regulatory
constraint
creates an implicit marginal cost 1f, of output. Both effects work to decrease the industry output
below the unregulated
Cournot output Xc.
4. Industry equilibrium under a design standard
Under a design standard
firm can be stated as:

The proof of this assertion

en the profit-maximization

problem

of a typical

is follows:

d[P(X)Xnm+P(X)]/dX=P(X)(l+nm)+P(X)Xn-
<P(X) + P(X)XC.
If P(X)sO,
the right-hand
side of (Fl)
which P(X) SO. If P(X) >O, then
F(X)+P(X)Xn-sP(X)+P(X)X

is negative,

which

(since XC

SO,
which proves the assertion

for the case in which P(X)>O.

(Fl)
proves
5X),

the assertion

for the case in

21

D. Besanko, Performance vs. design standards

max P(X)x - c(e)x - k(e)

s.t.

(8)

e2eD,
x20.
Again using Friedmans (1977) Theorem 7.8 an equilibrium
can be shown
exist. In equilibrium,
the regulatory constraint
(8) will be binding.
The condition for the symmetric industry equilibrium
output XD is:
P(XD)xD + P(XD) = c(e,),
where xD-XDnm.
This yields the following

to

(9)

characterization

of the industry

equilibrium.

Proposition 2. (a) If c >O and en >O, the industry equilibrium output XD is

less than the unregulated Cow-not industry output Xc; (b) ij c=O, the industry
equilibrium output equals the Cournot industry output.
Proof:

(a) If c > 0 and e, > 0, then c(en) > c(0). Thus:

p( XD)xD+ P( XD) > P( XC)xC + P( XC)

which implies XD <Xc.

(b) If c =0 the condition
precisely (9). Q.E.D.

for

the

unregulated

Cournot

equilibrium

is

Proposition 3. Under a design standard (a) industry output is nonincreasing in

the required amount of the e.c.i., i.e. dXDjdeD50;
(b) equilibrium pollution per
firm decreases in the required amount of the e.c.i., i.e. dqD/deD < 0.
Proof:
(a) Differentiating
xD = XD/n, yields:
[PxD +(l + n-l)P]

each side of (9) with respect to eD and noting

dXD/deD=c(eD).

The term in the square brackets

the result follows immediately.
(b) Using (1):

is negative

dqD/deD = f, dxD/deD + f, < 0.

?See Besanko

that

(1987) for a proof.

Q.E.D.

(see footnote

8) and c(e,)zO,

so

28

D. Besanko, Performance us. design standards

Because the equilibrium

pollution per firm, qD(eD), is a decreasing function,
we can invert this function to obtain the design standard
eD(qn) needed to
implement a target level qD of pollution per firm. This way of thinking about
design standard-setting
will prove useful in developing comparisons
between
performance
and design standards.

5. Comparison of performance and design standards

This section compares
the equilibria
that arise under a performance
standard and a design standard. Two types of comparisons
are made. In the
first subsection we compare a performance
standard q to a design standard
which induces an equilibrium
pollution per firm q. In the next subsection, we
compare an optimal performance
standard to an optimal design standard.
5.1. Comparison of industry equilibria for a fixed level of pollution per firm
The first result we present confirms the conventional
wisdom
mance standards are more cost-effective than design standards.

that perfor-

Proposition 4. For any target pollution level q, emissions costs are lower
under a performance standard than under a design standard.
Proof: To prove the result it is sufficient to demonstrate
that ep(q)<eD(q).
The proof is by contradiction.
Suppose, to the contrary, that eD(q) 5 eP(q).
Let XD(q) denote the equilibrium
industry output under a design standard
that induces a pollution level per firm of q, and xD(q) = XD(q)n- . From (9):

PWD(dbDM
+ JVD(q))- 4eDM)= 0.
By contrast,

(10)

from (3):

pWp(q))xpM
+ P(Xp(d)- 4eP(q))
>O.
By assumption,

eD(q) 2 e(q), so because

c 2 0, (10) and (11) imply:

p(XP(q))xP(q) + P(XP(q)) > P(XD(q))xD(q) + WD(q)).

The inequality

(11)

(12)

(12) implies:

XPM< XD(q).

(13)

But,
4=

f (xp(djeP(qh

(144

29

D. Besanko, Performance vs. designstandards

4=

f(xD(qLeD(d).

(1W

Because eP(q) LeD(q) and X(q) <XD(q),

neously hold. Thus, eP(q) < eD(q). Q.E.D.
An immediate

consequence

of Proposition

(14a)

and

(14b)

cannot

simulta-

4 is:

Proposition 5. For any target pollution level q, the industry output X(q)
under a performance standard is less than the industry output XD(q) under a
design standard.
Proof:

Because
4=

fbP(q),eP(q))
= f(xD(q),
eD(q

and eP(q) <eD(q), it follows that X(q) < XD(q).

Q.E.D.

Propositions
4 and 5 are depicted in fig. 1. The upward-sloping
line 00 is
the set of (x,e) pairs that generate
a constant
pollution
per firm. The
equilibrium
under a performance
standard q puts a firm at point R, where a
firms isoprofit contour
is tangent
to OO, while the equilibrium
under a
design standard
puts a firm at point S where a firms isoprofit contour
reaches its peak. The intuition
behind Propositions
4 and 5 is that under a
performance
standard
firms substitute
output for the e.c.i. to achieve the
pollution target q. Under a design standard, no such substitution
takes place.
Propositions
4 and 5 indicate the policy tradeoff the regulator faces under
SWM. If a performance
standard is used, the regulator sacrifices output for
low emissions
control costs while under a design standard,
the regulator
sacrifices emissions control costs for higher output. For a fixed pollution
target q the social welfare under a performance
standard
may or may not
exceed the social welfare under a design standard.
It has been argued by
some authors [e.g. Roberts and Farrell (1978)] that the objective functions of
environmental
regulators
typically include other factors besides emissions
control and pollution
costs. For example, state environmental
regulators
in
the United
States may be sensitive
to the employment
implications
of
pollution control regulations.
To the extent that social welfare maximization
is a reasonable
approximation
of regulatory
objectives in pollution
control,
our analysis provides a rationale unrelated to differences in enforcement
costs
why environmental
regulators
may prefer design standards
to performance
standards.
We next compare
a firms equilibrium
profit under
both types of
standards.
In the example
chosen optimally.

J.P.E.

in section

6 we show that the same ambiguity

arises when the standards

are

30

D. Besanko, Performance us. design standards

t(x,e):

f(x,e)

= 41

1)x) -

c(e)x
=

- k(e)
l?(q):

fx

Fig. 1. Comparison

of equilibrium

xD
under

performance
target.

and design standards

for a fixed pollution

Proposition 6. For any target pollution level q, a firms equilibrium profit

x(q) under a performance standard exceeds a firms equilibrium profit nD(q)
under a design standard.
Proof: Again recall that xD =XD[n]- and xp =XP[n]
. By assumption,
(xD, eD) and (xp, eP) both yield pollution per firm q, and therefore (xD, eD) is a
feasible choice for a firm under a performance
standard
qp= q. Because
(xP,eP) maximizes a firms profits in equilibrium,
this implies:
zP(q)=P(XP)xP-c(eP)xP-k(eP)
> P([l -n-]XP+xD)xD-c(eD)xD-k(eD).
Now, from Proposition

5, Xp < XD. Thus:

(15)

31

D. Besanko, Performance us. design standards

P( [ 1 -n-

Combining

]Xp + xD)xD - c(e)x - k(eD)

(15) and (16) yields the desired

result.

Q.E.D.

A firm prefers that a given amount

of pollution
be achieved
by a
performance
standard
rather than a design standard because a performance
standard gives the firm more flexibility in adjusting to the pollution
target.
[A firm can choose (x, e) instead of just x.1
5.2. Comparison of optimal standards
As indicated in the previous section, a regulator whose objective is SWM
faces a tradeoff in the use of performance
versus design standards.
By
contrast a regulator whose objective is CM has an unambiguous
preference
for performance
standards over design standards.
Proposition 7. When the regulators objective is CM, the optimal performance
standard results in a lower cost than an optimal design standard, i.e.
CP(n), where:
C(z) -min nk(eP(qp))+ B(nq,),
4P
s.t. ?TP(qp)
2 7z.

[CM-P]

c(n) = min %k(e( qn)) + B( nqn),

%
[CM-D]

s.t. nD(q,) 2 n.
Proof:

Let qf$ denote

the optimal

solution

to [CM-D].

Thus,

7c(4;) 2 n.
From

Proposition

(17)
6, it follows that

7cP(qfJ> 7cD(q;r)2 7-c.

Thus, qg is a feasible solution
eP(qg) < eD(qz), so that

(18)
to [CM-P].

Moreover,

nk(eP(qi9)
+ B(n&) < n4eDMi))+ B(nqi%

from

Proposition

4,

(19)

D. Besanko, Performance vs. design standards

32

Expression (19) implies that

costs
than
the
optimal
C(n) < C(n).
Q.E.D.

a feasible solution to [CM-P]

results in lower
solution
to
[CM-D].
This
implies
that

The result follows because performance

standards
induce a lower equilibrium quantity
of emissions input per firm and higher profit per firm than
does a design standard that results in the same equilibrium
level of pollution.
The implication
of this proposition
is that a regulator concerned
only with
costs would support
performance
standards
over design standards.
The
Congressional
Budget Office (CBO) has advocated
performance
standards
over design standards in air pollution precisely on grounds of cost effkiency.
According to Crandall (1983), the CBO has estimated that the cost of using a
scrubbing
standard
relative to the performance
standards
that had been in
place prior to 1977 would be about $2,400 per ton of SO, abated by the year
2000.

6. An example
To further compare performance
presented.
The specification of the example

and design

standards,

an example

will be

is:

f(x, 4 = x/e,
P(X)=a-X,
c(e) = 0,
k(e) = ke,
B( nq) = bnq.
6.1. Industry equilibrium under a performance standard
The equilibrium
quantity
output under a performance

ePkp)=

of e.c.i. per firm and the equilibrium

standard qp are given by:

CaCqpl~-kCqpl~21Cn+11~,qp2ka-,
q,<kaC;
0,
[a-k[qP]-]n[n+

XP(qp)

industry

o
3

l]-,

qpz ka-,
q,<ka-.

These functions
are depicted
in fig. 2. Fig. 2 indicates
that if the
performance
standard is sufficiently stringent (qp < ka- ) firms produce zero

33

D. Besanko, Performance OS.design standards

o/,,
ka-l

Fig. 2. Equilibrium

under performance

standard

for example.

output and use no e.c.i. As the standard is relaxed (qp is increased), each firm
initially
uses a higher quantity
of the e.c.i., but beyond a certain point
(q,,= 2ka-), further relaxation
of the standard induces each firm to reduce
e. The equilibrium
industry
output is a strictly increasing
function
of the
allowed pollution
qp per firm over the range where qp> ka-. As the
standard
is relaxed industry
output approaches
na[n + l] -I - the unregulated Cournot industry output.
6.2, Industry equilibrium under a design standard
The equilibrium
firm is given by

under

a design

standard

that

results

in pollution

qD per

D. Besanko, Performance vs. design standards

34

xD(q,)=na[n+l]-,
llq] -

eD(qD)=a[[n+

The e.c.i. quantity that generates an equilibrium

strictly decreasing
function, while the equilibrium
pendent of the pollution target qu.

qD per firm is a
output is inde-

pollution
industry

6.3. Optimal performance standard under SWM

To investigate
the tradeoffs present under SWM, we will investigate
the
optimal
performance
standard
under SWM in this section. In the next
section, we will characterize the optimal design standard under SWM.
Under SWM the regulator solves:
max Wp(qp) = aXP(qp) - ( 1/2)[Xp(qp)]
4P

- nkeP(qp)- bnq,

s.t.
xP(q,)

2 0,

where, for simplicity, the minimum allowed profit is assumed to equal zero.
Fig. 3 depicts social welfare as a function of qp. The function is defined at
qp=O and for qpE[ka-, CD), and the minimum
profit constraint
can be
shown to be satisfied for all values of qp in the domain of W(.).
The
function
W(.) can be shown to have no more than one local maximum.12
The global maximum
for W(.) will thus either be at this unique local
maximum
if Wp is positive at this point, or it will be at qp=O if Wp is
negative at the local maximum.
Assuming an interior optimum, the optimal performance
standard can be
shown to satisfy the first-order condition:13

(20)
Eq. (20) defines

the

optimal

standard

as a function

qp(n,u,b,k)

of the

Social welfare is not defined at qr~(O, ka-) because if the regulator sets a standard in this
interval, firms will produce
zero output and use no emissions control input. The regulator
constraint
will thus be slack over this interval and the actual level of pollution per firm will be
zero.
*However, for some parameter values it may not have a local maximum.
jThe second-order
condition can be shown to imply that q,z(3/2)ka-.
It can be shown that
the cubic equation in (20) has at most one root such that q,h(3/2)ka-.
If such a root exists
and if the solution to (20) is such that W(q,)>O, then (20) describes the global maximum.
If
(20) has no root that exceeds (3/2)ka- or if it does and that root is such that Wp(q,)<O, the
global maximum is qP=O.

35

D. Besanko, Performance us. design standards

t
Fig. 3. Social welfare under performance

standard.

number of firms and of demand and cost parameters.

Proposition
8 indicates
how the optimal standard varies with the number of tirms in the industry.
Proposition 8. For the example, as the number offirms in the industry increases
the optimal performance standard becomes more stringent, i.e. dq,/dn<O.
Proof.

of (20) with respect to n yields:

Differentiation
{k(n+2)(n+

1)p2q;3[3kq;

-kqi3(aq,-k)(5n+

-2a])

l)(n+

dq, /dn

1)-4=0.

The term in the curly brackets is negative

the regulators problem. Thus, dqddn ~0.
This

result

is driven

by two

effects.

14As can be seen from the numerical

example
total industry pollution QP=nqP decreases in n.

by the second-order
Q.E.D.
First,

below,

a benefit
this proposition

from

condition

relaxing

does not imply

of

the
that

D. Besanko, Performance OS.design standards

36

pollution
standard
is that a relaxed standard
induces more output. As n
increases, however, the marginal
benefit of output (i.e. the industry
price),
decreases. Thus, for any qr, the marginal
benefit of relaxing the standard
decreases in n. Second, as n increases the marginal social cost nb of relaxing
the standard
increases. Together,
these effects work to decrease qp as n
increases.
To further characterize
the optimal performance
standard some numerical
examples
are presented
in table 1. The examples
indicate
the optimal
standard becomes less stringent as demand shifts outward (a increases) and
as the marginal
emissions control cost k increases. The standard
becomes
more stringent as the marginal social cost b of pollution
damage increases.
Table 1 also indicates that even though pollution
per tit-m declines with n,
total industry
pollution
QP=nqp rises with n: a tighter
standard
is not
sufftcient to offset the pollution of an additional firm.
The numerical examples also indicate that under an optimal performance
standard, social welfare does not unambiguously
increase with the number of
Table 1
Optimal
a=lOO,
II
1
2
5
10
20
100
a=lOO,

k=lO,
qP
8.61
6.62
4.36
3.09
2.18
0.95
k=20,

b=lO

QP
8.61
13.24
21.80
30.90
43.60
95.00

qP

Q'

1
2
5
10
20
100

12.14
9.32
6.13
4.35
3.05
1.30

12.14
18.64
30.75
43.50
61.00
130.00

k=lO,

standards.

a=lOO,

W%P)
3,511
4,179
4,423
4,194
4,105
3,052

b=lO

a=200,

performance

n
1
2
5
10
20
100

k=lO,
qP
1.02
5.39
3.55
2.52
1.71
0.16

a= 100, k=20,

WqP)
3,506
4,069
4,243
4,078
3,746
2,280

b=2

?I
1
2
5
10
20
100

qP
9.90
7.60
4.99
3.53
2.47
1.04

a=3OQ, k=lO,

b=lS

QP
7.02
10.78
11.75
25.20
35.40
76.00

W%lP)
3,539
4,119
4,325
4,195
3,910
2,630

b= 15

QP
9.90
15.20
24.95
35.30
49.40
104.00

WqP)
3,452
3,986
4,105
3,883
3,472
1,702

b=2

qP

QP

wphJ

qP

QP

W%lP)

1
2
5
10
20
100

21.36
21.05
13.92
9.93
7.04
3.14

27.36
42.10
69.60
99.30
140.80
314.00

14,890
17,609
19,166
19,436
19,390
18,738

1
2
5
10
20
100

33.52
25.80
17.06
12.18
8.63
3.85

33.52
51.60
85.30
121.80
172.60
385.00

33,616
39,193
43,409
44,141
44,207
43,450

37

D. Besanko, Performance vs. design standards

producers in the market as it would in an unregulated

Cournot equilibrium.
This occurs for two reasons. First, emissions control costs are fixed so the
regulatory
constraint
induces economies
of scale. Secondly,
as indicated
previously, total industry pollution rises as n increases, so the social costs of
pollution damage rise as more producers are added to the market. Together,
these effects reduce welfare as n increases
and counterbalance
the procompetitive
effects on the product market equilibrium
from having a large
number of producers. 5
6.4. Optimal design standards under SWM
The regulators

problem

is

max WD(q,) = aXD(q,) -( 1/2)[XD(q,)]

%

- nkeD(qD)- nbq,

St.

The constraint
indicates the pollution
targets under which the equilibrium
profit of each firm is non-negative.
The function WD(qD), sketched in fig. 4,
can be shown to be strictly concave over the range [k[a/[n+ l]]-, co). The
global maximum will thus either be the local maximum qz in the figure or at
qn=k[a/[n+
l]]-.
Assuming an interior solution, the optimal pollution target per firm can be
shown to equal
q,={akb-[n+
which implies

1]-1)1/2,

that the optimal

(21)

design standard

is equal to
(22)

The expressions in (21) and (22) allow us to establish

of Proposition
8.

the following

analogue

Proposition 9. For the example, as the number of firms in the industry

increases: (a) the original pollution target becomes more stringent, i.e.
dqddn<O;
(b) the design standard that implements the optimal pollution target
is relaxed, i.e. den/dn < 0; (c) total industry pollution increases, i.e. dQD/dn > 0.
15An analogous
tradeoff
analyzed by Perry (1984).

between

economics

of scale

and

imperfect

competition

has

been

38

D. Besanko,

Performance

vs. design standards

Fig. 4. Social welfare under a design standard

Proof
Parts (a) and (b) follow immediately
from (21) and (22). Total
industry pollution QD under the optimal design standard is given by
QD(n)-nqD=n[n+l]-lZ[akb-]Z.
Differentiation

(23)

of (23) with respect to n yields:

dQD/dn=(1/2)[n+2][n+1]-32[akb~]2>0.

Q.E.D.

The e.c.i. quantity decreases as the pollution

target decreases because the
output of each firm decreases in n. Thus, with more producers in the market
the regulator can relax the design standard and still achieve a lower quantity
of pollution per firm.
Part (a) of Proposition
9 pertains
only to an interior
solution
to the
regulators problem. If II is sufficiently large, a corner solution in which qD=
k[n+ l]/a can be shown to be optimal.
In this case the optimal pollution
target increases in n.
6.5. Comparison
The tradeoff

of performance

between

and design standards

performance

and design

standards

under

SWM

will

D. Besanko,

Performance

39

OS.design standards

now be considered.
As a first step, the expressions
for the equilibrium
industry output and e.c.i. can be shown to imply that for q~ [ka-, co), the
difference W(q) - WD(q) between total welfare under a performance
standard
and a design standard for any pollution target q is given by:
W(q)-

Wyq)=nk[[n+

l]q]-2[(1/2)[n+2]k-aq].

This expression can be used to derive a sufficient

standard to dominate a design standard.
Proposition

Proof

for a performance

IL in the example,

10.

(n+2)(n+
the regulator

condition

(24)

1)12~2a32kP12bK12,

will prefer a performance

standard

(25)
to a design standard.

Define
(26)

and let qg and qp* be the optimal pollution

targets under a design standard
and performance
standard, respectively. We now show that if d(qE) >O, then
maximum
welfare W(qp*) under a performance
standard exceeds maximum
welfare WD(qg) under a design standard. Because d(qg) > 0,

WD(q3
< WD(qi3
+ 44%
= W(qE)

Now, if qI:=k[a/[n+l]]-,
and only if (25) holds.

[from (24)]

d(q:)>O.

If q~={akb-[n+1]-}12,

d(qg)>O

if

Q.E.D.

The sufficient condition

(25) is more likely to hold when b, k, and n are
large and when a is small. Thus, a performance
standard
is likely to
dominate
a design standard when marginal emissions-control
and marginal
pollution costs are large and when demand is low. Finally, when the number
of firms is large, the regulator
is more likely to prefer a performance
standard.
The relationship
between
market
structure
and the choice of
standard
stems from the interaction
between the pollution
externality
and
imperfect
competition.
The pollution
externality
distorts
output
upward
while imperfect competition
distorts output
downward.
The performance

D. Besanko, Performance vs. design standards

40

standard
counteracts
the upward distortion
of output, but the downward
distortion
remains. The design standard deals inefficiently with the pollution
externality
because it does not induce firms to take into account
the
marginal
effects of output
on pollution.
However,
it leaves open the
possibility that the downward output distortion due to imperfect competition
will be offset by the upward
output
distortion.
When the downward
distortions
are less serious (high n) this possibility
is less likely, and a
performance
standard is more likely to be preferred to a design standard.
A comparison
between
optimal
performance
and design standards
is
presented
in table 2. As the preceding
analysis
suggests,
performance
standards
dominate
design standards
when the number of producers in the
industry
is sufficiently
large, while design standards
dominate
when the
number of producers is small.

7. Performance

standards and emissions taxes

Suppose
that instead
of setting a performance
standard
or a design
standard,
the regulator
levied an emissions tax t on each firm. Each firm
would then face the problem:
max P(X)x-c(e)x--k(e)

-tf(x,e)

s.t.

Table 2
Comparison
of optimal performance
standards
and optimal design standards.
a=lOO, k=20,
?I

Wp*

WD*

1
5
10
20
60
80
100

3,452
4,105
3,883
3,472
2,413
2,032
1,702

3,505
4,154
3,914
3,215
-6,143
- 14,563
-25,399

Wp* = maximum
standard.
WD = maximum
standard.

b=15
sign[ Wp* - WD*]
+
+
+
+

social welfare, performance

social

welfare,

design

D. Besanko, Performance vs. design standards

41

Let xT, eT denote the equilibrium

output and e.c.i. per firm and let qT=
It is well known that in the absence of uncertainty
or asymmetric
information,
the regulator can implement the equilibrium
under an emissions
tax by setting an appropriately
chosen performance
standard
[see, for
example, Dasgupta and Heal (1979)]. In this case, the performance
standard
qp = qT will implement
the equilibrium
under the emissions tax.
Because a design standard
may dominate
a performance
standard
if the
regulators objective is social welfare, this result implies that the regulator
may prefer a design standard to a tax, even in the absence of considerations
such as uncertainty
or asymmetric information.

f(xT,eT).

8. Discussion

and extensions

Because the formal model presented in the previous section is fairly simple,
it understates
the richness of the standard-setting
problem in the real world.
The objective of this section is to discuss a number of important
issues in the
standard-setting
problem
that our model ignores and to suggest possible
directions for future research into the standard-setting
problem.
By modelling regulation
as a simple constraint,
we are implicitly assuming
that the regulator is able to continuously
monitor the firms compliance
with
the standard and that the regulator can impose on the firm suficiently
stiff
penalties for noncompliance
with the standard. An extension of our analysis
would be to assume that pollution
cannot be monitored
perfectly and that
monitoring
is costly. The regulator would then be faced with the problem of
how frequently to monitor compliance.
In a model with positive monitoring
costs, it seems plausible to expect that continuous
monitoring
is not optimal.
This will weaken the effects of standards
whose compliance
is difficult to
monitor. A very stringent pollution
performance
standard whose compliance
is monitored
only infrequently
could well induce the firm to invest less in an
e.c.i. than it would under a very lax design standard which can be monitored
much more frequently.
Thus, an important
consideration
in choosing
a
performance
or a design standard would be the relative costs of monitoring.
In pollution
regulation
it may be relatively easy to monitor certain forms of
pollution
(e.g. air pollution
by an electric utility) but relatively difficult to
monitor
other forms of pollution
(e.g. contamination
of soil by PCBs). In
many cases it is conceivable
that differences
in monitoring
costs could
dominate the economic tradeoffs identified in our theoretical model.
Another important
aspect of the enforcement
problem in standard-setting
is the existence of limitations
on penalties for violating standards.
In most
cases the regulatory
agency bears the burden
of proof in establishing
a
record of noncompliance.
In addition, the magnitude
of the penalty is often
left to the discretion of the regulator or the courts. For example, under the
Clean Air Act Amendments
of 1977, Congress left unspecified the penalties

42

D. Besanko, Performance us. design standards

for noncompliance
but directed the Environmental
Protection
Agency to
consider a variety of factors (including severity of the pollution damage and
the impact of the penalty on the violating firm) in assessing penalties [Farber
and Martin
(1986)]. Typically,
the agency must go through
extensive
administrative
and legal proceedings
before a line can be assessed. Sometimes the outcome of these proceedings
is a revision of the standard
and
not the assessment of a penalty [Breyer (1982)]. For first-time violators of
standards,
penalties are usually not assessed [Roberts and Farrell (1978)].
When penalties are assessed they are often small in relation to the assets of
the violating
firm. Because penalties
are often small, firms will find it
advantageous
to violate the standard, and the regulator must take this into
account
in the formulation
of the standard.
With respect to the choice
between performance
and design standards, the size of the penalty may be an
important
consideration.
Courts
will generally
not impose penalties
for
violations
of standards
when those penalties
do not bear a reasonable
relationship
to the expected damage resulting from the violation. Thus, one
might expect a tendency for the courts to impose a higher penalty for a
violation of a pollution performance
standard than for a violation of a design
standard
because in the former case the perceived damages from overpolluting may seem far more substantial
than the perceived damages from
installing the wrong type of pollution control equipment.
Another
issue ignored
in our model is that firms may be able to
successfully
circumvent
the standards
without legally violating
them. For
example, under a design standard,
a firm might install pollution
control
equipment
and then let it sit idle if the use of the equipment
adds to the
marginal cost of the final product. What prevents a firm from doing this in
our model is our implicit assumption
that the regulator not only monitors
the installation
of the e.c.i. but verifies that it is used and maintained
to its
fullest level of efficiency. In practice, if inspection resources are limited and if
the pollution
control inputs are sufficiently complex, verification
efforts by
the regulator may turn out to be quite superficial. Indeed, the regulator may
end up making
inferences
about the efficiency of the emissions
control
procedures by observing actual emissions. But in this case, what is nominally
a design standard in fact becomes a performance
standard.
The firms may also be able to legally circumvent
a performance
standard.
If, for example, the performance
standard
is viewed as an endowment
of
marketable
rights to pollute (see footnote 4) then two or more firms in the
industry may have an incentive to merge in order to relax the performance
standard. l6
?Salant
Switzer and Reynolds (1983) have shown that in a symmetric Cournot model with
linear demkd
and linear marginal cost horizontal
mergers are generally unprofitable
unless all
firms in the industry merge together to form a monopoly.
An open question is whether the
presence of performance
standards alters this result, at least in some cases.

D. Besanko, Performance vs. design standards

43

A final important
issue that we have ignored in our model is the effect of
pollution standards on entry. The imposition
of standards raises the costs of
entering the regulated industry.
Because performance
standards
give firms
more flexibility
than design standards,
it would seem that performance
standards would have less harmful effects on entry than design standards. Of
course, in the spirit of Salop and Scheffman (1983) and Rogerson (1984),
incumbent
firms may have a preference for design standards
for this very
reason. An important
and worthwhile extension of our analysis would be to
examine the implications
of alternative
regulatory
regimes for entry and to
study the preferences
of both the regulator
and the firms for regulatory
regimes
when the full impacts
of alternative
types of standards
are
considered.

9. Summary and conclusions

The conventional
wisdom on standard-setting
in pollution
seems to be
that, absent considerations
of enforcement
costs, performance
standards
should be preferred to design standards
because performance
standards give
firms more flexibility to adjust to the standard and thus pollution targets can
be achieved at a lower cost. The principal policy implication
of this analysis
is that the conventional
wisdom is correct if one counts only emissions and
damage costs. If, however, one also counts the impact of pollution regulation
on the output supply decisions of firms, then it is no longer the case that
performance
standards
dominate
design standards,
and the choice between
the two (in the absence of enforcement
cost differences) will depend on
parameters of the demand and cost functions and on the market structure of
the regulated industry.

Baron, D.P., 1985a, Noncooperative

regulation
of a non-localized
externality,
Rand Journal of
Economics 16, 5533568.
Baron, D.P., 1985b, Regulation of prices and pollution under incomplete information,
Journal of
Public Economics 28, 21 l-231.
Besanko, D., 1987, Standard setting in pollution regulation: A comparison
of regulatory
regimes,
unpublished
working paper.
Breyer, S., 1982, Regulation and its reform (Harvard University Press, Cambridge,
MA).
Crandall,
R.W., 1983, Air pollution, environmentalists,
and the coal lobby, in: Roger G. No11
and Bruce M. Owen, eds., The political economy of deregulation:
Interest groups in the
regulatory process (American Enterprise Institute, Washington,
D.C.).
Dasgupta, P.S., 1982, The control of resources (Harvard University Press, Cambridge,
MA).
Dasgupta,
P.S. and G.M. Heal, 1979, Economic
theory and exhaustible
resources (Cambridge
University Press, Cambridge, UK).
Dasgupta,
P.S., P.J. Hammond
and E.S. Maskin, 1979, On imperfect information
and optimal
pollution control, Review of Economic Studies 46, 1855216.
Farber, S.C. and R.E. Martin, 1986, Market structure
and pollution
control under imperfect
surveillance, The Journal of Industrial Economics 35, 1477160.

44

D. Besanko, Performance us. design standards

Friedman, J.W., 1977, Oligopoly and the theory of games (North-Holland,

Amsterdam).
Kwerel, E., 1977, To tell the truth: Imperfect information
and optimal pollution control, Review
of Economic Studies 44, 595601.
Perry, M.K., 1984, Scale economies,
imperfect
competition,
and public policy, Journal
of
Industrial Economics 32, 313-333.
Roberts, M.J. and SO. Farrell, 1978, The political economy of implementation:
The Clean Air
Act and stationary
sources, in: A. Friedlander,
ed., Approaches
to controlling
air pollution
(MIT Press, Cambridge,
MA).
Rogerson,
W.P., 1984, A note on the incentive for a monopolist
to increase fixed costs as a
barrier to entry, Quarterly Journal of Economics 99, 39942.
Salant, S.W., S. Switzer, and R.J. Reynolds, 1983, Losses from horizontal
merger: The effects of
an exogenous change in industry structure on Cournot Nash equilibrium,
Quarterly
Journal
of Economics 98, 185-199.
Salop, S.C. and D.T. Scheffman,
1983, Raising rivals costs, American Economics
Review 73,
267-271.
Spence, A.M. and M.L. Weitzman,
1978, Regulatory
strategies
for pollution
control,
in: A.
Friedlander,
ed., Approaches
to controlling
air pollution (MIT Press, Cambridge,
MA).