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Bård Harstad

http://www.sv.uio.no/econ/personer/vit/bardh/dokumenter/uphd2.pdf

Abstract

This lecture note studies stochastic games and contract theory, and illustrates

how to combine the two. We will discuss:

(1) Dynamic and stochastic games

(2) Incomplete contracts and hold-up problems

(3) Optimal contracts and duration

(4) Renegotiation and renegotiation design

(5) Complete contracts, spillovers, and R&D subsidies

1. Introduction

These notes study dynamic games where both pollution stocks and technology stocks

cumulate over time. Furthermore, and more importantly, the notes allow for so-called

"legally binding agreements," where we assume that countries may be able to (in part)

commit to certain emission levels.

If countries can commit to any future action (emission as well as technology), then

the …rst best can easily be achieved. In reality, however, commitment is only imperfect:

Countries may not be able to commit to the very long term, and some actions may not

be possible to measure or observe, or commit to, at all.

For example, the importance of developing new and green technology has been recog-

nized in the treaty texts, but the "technology needs must be nationally determined, based

on national circumstances and priorities."1 Thus, both past and future agreements are

likely to prescribe emission levels rather than investments in technology. To some extent,

commitments on emissions will motivate countries to invest in new technology. However,

there are large externalities or technological spillovers associated with such investments.

When surveying the literature, IPCC (2014, Ch. 13:50) concludes that "the evidence

indicates a systematic [positive] impact of IP protection on technology transfer." It may

thus be comforting that the Agreement on Trade Related Aspects of Intellectual Property

Rights (TRIPS) of 1994 generally commits all countries to create and enforce standard

intellectual property rights. TRIPS, however, allows for exceptions to the exclusive rights

of patents for public policy reasons. It provides for the possibility of compulsory licensing

and royalty-free compulsory licensing has indeed been advocated for as a way to encourage

technology transfers (IPCC, 2014, chap. 13:50; 15:47). Also the 2015 Paris agreement fo-

cused on emissions, while investments in new technology was not something anyone tried

to specify. Furthermore, the commitments under the Paris agreement is only to 2025 (for

some countries) or 2030 (for others).

This raises several important questions. How valuable is such an agreement with a

relatively short duration? What is the optimal term of this agreement? How should the

term, and the design more generally, be in‡uenced by actual intellectual property rights

and the requirements for licensing?

These lecture notes present a dynamic framework in which countries both pollute

and invest in technology during every period. The pollution as well as the technology

stocks depreciate but accumulate over time. The technology, which could involve either

renewable energy sources or abatement technology, reduces the need to pollute. While

the model has a large number of subgame perfect equilibria, I focus on the symmetric

Markov perfect equilibrium (MPE) since it is simple, robust, and unique. If countries

cannot commit to any future action, the game is a dynamic version of the common-pool

problem. If countries can contract on every future action, they easily implement the …rst-

best outcome. The more realistic and interesting situation arises when countries contract

on emission but not investment levels.

1

The quote is from §114 in the Cancun Agreement (UNFCCC, 2011), con…rmed by the Durban

Platform (UNFCCC, 2012).

2

While these notes abstract from more general functional forms, heterogeneity among

the countries, and renegotiation, they intend to make a number of important policy

lessons:

First, climate agreements can reduce welfare relative to business as usual. When fu-

ture negotiations are anticipated, countries may fear being held up by the others when

negotiating emission quotas.2 This hold-up problem reduces the incentive to invest, and

every country may be worse o¤ with short-term agreements than in the business-as-usual

scenario in which no negotiations or agreements ever occur. Speci…cally, climate agree-

ments are likely to be harmful if intellectual property rights are weak, the commitment

period is short, and the number of countries large.

Following the pessimistic result above, the optimal climate treaty is characterized.

If quotas are negotiated before a country invests, it cannot be held up by the other

countries–at least not before the agreement expires. Thus, countries invest more when

the agreement is long-term. Nevertheless, countries underinvest compared to the opti-

mum if technological spillovers are positive or intellectual property rights are weak. To

compensate for this and to encourage further investments, the best (and equilibrium)

treaty is tougher, in that it stipulates lower emissions, relative to what is optimal ex post,

once the investments are sunk. The weaker the intellectual property rights, the tougher

the optimal (and equilibrium) treaty.

Finally, the optimal length of the agreement is characterized. On the one hand, a

longer time horizon is required to minimize the hold-up problem and to maximize the

incentive to invest in technology. On the other hand, the future marginal cost of pollution

is uncertain and stochastic in the model, and it is hard to predict the ideal quotas in the

far future. The optimal length trades o¤ these concerns. If intellectual property rights

are strengthened, for example, the optimal length decreases.

The optimal climate treaty is a function of trade policies, but the reverse is also true: if

the climate treaty is relatively short-term, it is more important to strengthen intellectual

property rights, reduce tari¤s, or subsidize technological trade. Negotiating such trade

2

The New York Times reports that "Leaders of countries that want concessions say that nations like

Denmark have a built-in advantage because they already depend more heavily on renewable energy"

(October 17, 2008: A4).

3

policies is thus a strategic substitute for a tough climate agreement.

By analyzing environmental agreements as incomplete contracts in a dynamic game,

I contribute to three strands of literature.

The model is presented in the next section. Section 3 presents the (complete contract-

ing) …rst-best outcome as well as the (noncooperative) business-as-usual scenario. The

fact that short-term agreements can be harmful is shown in Section 4, while Section 5

characterizes the optimal agreement. Section 6 discusses trade policies and shows that

the main results hold whether or not side transfers are available or the emission permits

are tradable. The …nal section concludes and the proofs follow in the appendix.

The model is presented in the next section. When solving the model in Section 3, we

gradually increase the possibilities for negotiations and contracts: (i) no cooperation, (ii)

short-term agreements, (iii) long-term agreements, and (iv) long-term agreements with

renegotiation. We start out by assuming that investments are noncontractible, technolo-

gies nontradable, quotas nontradable, …rms nonexistent, and countries homogeneous. We

will discuss how these assumptions can be relaxed in Sections 4 and 5. Further readings

are discussed in Section 6. Most proofs are in the the Appendix s.

2. Stochastic Games

This section presents a game where n players over time contribute to a public good and

invest in technology. The purpose of the technology is to reduce the cost of providing

public goods in the future. While the model is general, let climate change …x ideas. I will

thus refer to the players as countries, the public good (or its negative: the public bad) as

the stock of greenhouse gases, and to contributions as emissions. For the most part, we

will abstract from heterogeneities within countries and oil exhaustability. The strategic

e¤ects studied below would survive if these complications were added to the model.

While a repeated game looks identical at the start of every period, a dynamic game,

and a stochastic game, can change from period to period in accordance with variables

described the state or the payo¤-relevant stocks.

4

The public bad is represented by the stock G of greenhouse gases in excess of its natural

level. Since the natural level is thus G = 0, G tends to approach zero over time (were it

not for emissions), and 1 qG 2 [0; 1] measures the fraction of G that "depreciates" every

period. G may increase, nevertheless, depending on the emission level gi from country

i 2 f1; :::; ng:

X

G = qG G + + gi : (2.1)

i

G represents the stock of greenhouse gases left from the previous period; subscripts for

periods are thus skipped. The shock , arbitrarily distributed with mean 0 and variance

2

, captures Nature’s stochastic impact on G. Note that, although the shock t is i.i.d.

across periods, it has a long-lasting impact through its e¤ect on G (or on ). The additive

form in equation (2.1) is standard in the literature.3 We will abstract from country-speci…c

uncertainty.

The other type of stock is technology. The technology stock in country i is measured

by Ri , and it depreciates over time at the rate 1 qR 2 [0; 1]. If country i invests

ri units in technology, Ri increases directly by dri units and, allowing for technological

spillovers, Rj may increase by eri , 8j 6= i. Such spillovers are empirically important (see

Coe and Helpman, 1995, or Golombek and Hoel, 2004, for several references in the …eld

of environmental economics.)

X

Ri = qR Ri; + dri + erj : (2.2)

j6=i

P

Assuming the spillover is imperfect, d > e. The total e¤ect on R i Ri is de…ned

by the primitive constant D d + e (n 1). The simple externality e may represent

traditional technological spillovers, di¤usion, imitation, licensing, or trade. In particular,

if traditional measures of intellectual property rights (IPR) are strengthened, then e may

decrease (while d can increase so that d + (n 1) e stays constant).

With only one type of technology, we cannot distinguish among innovation, develop-

ment, di¤usion, and learning by doing. Thus, several interpretations of Ri are consistent

3

The additive form of the noise is standard in the literature on di¤erential games (Başar and Olsder,

1999: Section 6.4; Dockner et al., 2000, Section 8.2), particularly when using quadratic functions (Engw-

erda, 2005: Section 9.1). The additive form of qG G and the assumption that qG 2 (0; 1) are particularly

natural in pollution settings (Dutta and Radner, 2004 and 2009).

5

with the model. For example, Ri may measure i’s abatement technology, i.e., the amount

by which i can at no cost reduce (or clean) its potential emissions. If energy production,

measured by yi , is generally polluting, the actual emission level of country i is given by:

gi = yi Ri . (2.3)

Alternatively, Ri may measure the capacity of country i’s renewable energy sources (or

"windmills"). If the windmills can generate Ri units of energy, and the alternative is to

use polluting fossil fuels, the total amount of energy produced is given by yi = gi + Ri )

(2.3).

Relying on (2.3), rather than focusing on technologies that reduce the emission content

of each produced unit (e.g., gi = yi =Ri ), simpli…es the analysis tremendously. An equally

helpful assumption is to let the investment cost be given by k (ri ). The additive form of

(2.3) has thus also been adopted elsewhere in the literature.4

Let the bene…t of consuming (and producing) energy be given by the increasing and

concave function B (yi ). If C (G) is an increasing convex function representing each coun-

try’s cost of the public bad, i’s utility in a period is:

With this, we are assuming a linearly separable utility function. It is important to recog-

nize the limitations of this, and to think about the consequences of relaxing this assump-

tion. Note, however, then when we abstract from uncertainty, maximizing ui is similar to

maximizing any monotonicly increasing function of ui . The results may thus be the same

if the real objective function is a Cobb-Douglas function:

e (yi )

B

;

e (G) e

C k (ri )

since, if we take the natural log of this equation, we can a linearly separable function

similar to (2.4).

Although we for some results can keep the functional forms in (2.4) general, we will

start by considering a linear investment cost, k (ri ) = Kri . In reality, the cost of investing

4

See, for example, Bos et al. (2014), analyzing how investment-contests can be designed to implement

the …rst–best. If the model focused instead on technologies that reduced the emission content of each

produced unit (as in Dutta and Radner, 2004), the analysis below would be much harder.

6

in technology can be a convex or a concave function (if there are increasing returns to

scale). Imposing linearity is thus a strong assumption, but it permits a tractable model

despite the n + 1 stocks.

In addition, we will be able to derive additional results by occassionally considering

the quadratic functional forms:

b c

B (yi ) = (y yi )2 and C (G) = G2 : (Q)

2 2

Here, parameters b > 0 and c > 0 measure the importance of energy and climate change.

The bliss point y represents the ideal energy level if there were no concern for pollution: no

country would produce more than y due to the implicit costs of generating, transporting,

and consuming energy. We can easily allow for heterogeneous bliss points y i ’s (see the

proofs).

Remarks on : The stochastic shock has a minor role in the model and most of the

results hold without it (i.e., if = 0). But the future marginal cost of emissions is in

reality uncertain, and this can be captured by . In fact, the model would be identical

b qG G + P gi and the uncertainty were in the

if the level of greenhouse gases were G i

b

associated cost-function, a¤ecting C but not G:

ui = B (yi ) b+

C G Kri ; where = qG + :

b and

Most results would continue to hold even if the e¤ects of G were not additive.5

Note that, although is i.i.d. across periods, it has a long-lasting impact through its

e¤ect on G.

Alternative interpretations: Instead of interpreting yi as "energy," we could substitute

(2.3) in B (:) and let B (gi + Ri ) measure i’s direct bene…t of adding to the public bad

(e.g., due to saved abatement costs). Better technology is then a perfect substitute for

producing the public bad. The public bad does not, of course, have to be greenhouse gases.

Moreover, by de…ning a public good as G and contributions as gi , i’s marginal cost of

providing the public good is B 0 (Ri ( gi )), increasing in i’s contribution but decreasing

in i’s technology. Hence, the model …ts many situations (with private provision of public

5

The exceptions are the results below that rely on quadratic utility functions.

7

goods or bads) beyond climate change.

To allow for alternative applications and to simplify the analysis, note that we have not

required gi or ri to be positive. Even for climate policies, a negative gi may be technically

feasible if carbon capture is an option, although this may be costly, as captured by a large

B 0 (:) for such a small gi . Similarly, ri may be negative if the abatement technology and

the associated infrastructure can be put to other uses.

2.2. Timing

The timing of dynamic games must be speci…ed. Here, it is natural to assume that the

investment stages and the pollution stages alternate over time. Somewhat arbitrarily, we

de…ne "a period" to be such that the countries …rst (simultaneously) invest in technology,

after which they (simultaneously) decide how much to pollute. In between, is realized.

Information is symmetric at all stages.

It is important for tractability that investments and emissions are decided on at dif-

ferent points in time.6 On the other hand, it is not important that the uncertainty be

realized between the investment stage and the emission stage, rather than vice versa. We

do not require the ri;t ’s or the gi;t ’s to be strictly positive.

Country i’s objective is to maximize the present-discounted value of its future utilities,

X

1

t

Ui = ui; ;

=t

where is the common discount factor and Ui is i’s continuation value as measured at

the start of period t. As mentioned, subscripts denoting period t are often skipped.

repeated games. To be able to make more precise predictions, re…nements are necessary.

In dynamic and stochastic games, it is common to focus on Markov perfect equilibria

6

This assumption can be endogenized. Suppose the countries can invest at any time they want but

2 (0; 1) measures time required for the technology to mature or be built. Then, in equilibrium all

countries will invest at time t 2 (t 1; t).

8

Figure 2.1: The investment and emission stages alternate over time.

(MPEs) in which strategies are conditioned only on the payo¤-relevant stocks (G and

R fR1 ; :::; Rn g). Note that this restriction would not make much sense in a repeated

game, since there there is no state or payo¤ relevant stock, so the MPE would simply be

the Nash equilibrium of the stage game.

There are several general reasons for selecting the Markov perfect equilibria. First,

Markov perfect strategies are simple, since they do not depend on the history in arbitrary

ways (Maskin and Tirole, 2001), which simpli…es the analysis as well. Second, experi-

mental evidence suggests that players tend toward Markov perfect strategies in complex

environments (Vespa, 2012; Battaglini et al., 2013). Third, focusing on the MPEs is

quite standard when studying games with stocks. Using an MPE in this note clari…es my

contribution to the literature.

In addition, Markov perfection is particularly attractive in the present model. In

contrast to much of the literature, there is a unique symmetric MPE in the present

game. This sharpens the predictions and makes institutional comparisons possible. The

restriction to symmetric MPEs means that if every country faces identical continuation

values at the investment stage, then we select the equilibrium where they invest the same

amount.7

This equilibrium coincides with the unique symmetric subgame perfect equilibrium if

time were …nite but approached in…nity.8 This is particularly important in the present

7

Since the investment cost is linear, there are asymmetric MPEs in which the countries invest di¤erent

amounts. In fact, if parameter b, c or k varied across countries, the MPE would have to be asymmetric

(they are thus analyzed in Harstad, 2012). In the present model, however, the asymmetric equilibria

would cease to exist if there were a slightly convex cost function for the investments ri;t . An additional

justi…cation is provided by Maskin and Tirole (1988:556), who also emphasize the symmetric MPE in

their model: "Our emphasis on symmetric equilibrium is meant to underscore the idea that the …rms are

inherently identical, so that, placed in the same circumstances, they should behave the same way".

8

This fact can easily be seen by the recursive nature of the proofs (see Harstad, 2012, for an explicit

proof). Fudenberg and Tirole (1991:533) suggest that "one might require in…nite-horizon MPE to be

9

context, since the equilibrium is then robust to the introduction of real-world aspects

that would make the e¤ective time horizon …nite. For example, since fossil fuel is an

exhaustible resource, the emission game may indeed have a …nite time horizon in the

real world. Similarly, politicians’ term-limits or short time horizon may force them to

view time as expiring. Finally, since the unique MPE makes it impossible to enforce

agreements by using trigger strategies, it becomes meaningful to focus instead on settings

where countries can negotiate and contract on emission levels–at least for the near future.

This note does not attempt to explain how countries can commit, but domestic rati-

…cation is seldom meaningless. In the United States, for example, the Supremacy Clause

(Article VI, paragraph 2 of the US Constitution) states that "all Treaties made... shall

be the supreme Law of the Land..." Thus, US states are bound to uphold a signed treaty,

even in the presence of con‡icting state laws. However, since nations’ability to commit

may in general be imperfect, I analyze alternative scenarios where countries cannot com-

mit at all (Section 3.3), where they can sign complete contracts (Section 3.2), or where

they contract on some but not all issues of interest (Sections 4-6). The last scenario turns

out to be most interesting analytically. This is also the scenario best describing current

climate negotiations. Note that I do not allow countries to commit to rules for how they

should negotiate in the future.9

At the negotiation stage, we will assume the bargaining outcome is e¢ cient and sym-

metric if it should happen that the game and the payo¤s are symmetric. This condition

is satis…ed whether we rely on (i) the Nash Bargaining Solution, with or without side

transfers, (ii) the Shapley value, or instead (iii) noncooperative bargaining in which one

country is randomly selected to make a take-it-or-leave-it o¤er specifying quotas and side

payments.

limits of …nite-horizon MPE."

9

For example, a commitment to uniform quotas could raise e¢ ciency for short-term agreements, and

would implement the …rst best if e = 0 and the uniform quota was determined by a majority requirement

short of unanimity.

10

3. General Analysis

This section solves the game above, gradually increasing the possibilities for negotiating

and contracting. Several contracting environments are analyzed in the following subsec-

tions:

Contract Complete None Incomplete + reneg.

One-period 3 5

1 2

Multiperiod 4 6

Naturally, di¤erent contracting environments generate di¤erent outcomes. Neverthe-

less, all the contracting environments share a number of attractive features. Rather than

repeating these features for each case, let us start by emphasizing them (although they

will be proven only later).

P

(1) The individual continuation value U is a function of only G and R N Ri; .

(2) Continuation values are linear in the stocks and satisfy:

@U (G ; R ) K

= qG (1 qR ) ;

@G n

@U (G ; R ) K

= qR :

@R n

(3) There is a unique symmetric MPE.

(4) This MPE coincides with the unique symmetric SPE if time is …nite, t 2 1; ::; t ,

and t < t 1.

the n + 1 stocks G and R [R1 ; R2 ; :::; Rn ]. However, note that choosing gi is equivalent

to choosing yi , once the Ri s are sunk. Thanks to the assumption that technology and

emissions are perfect substitutes, by combining (2.1) and (2.3), we get:

X

G = qG G + yi R.

N

This way, the Ri s are eliminated from the model: they are payo¤-irrelevant as long as R

is given, and i’s Markov perfect strategy for yi is therefore not conditioned on them.10

10

This follows from the de…nition by Maskin and Tirole (2001: 202), where Markov strategies are

measurable with respect to the coarsest partition of histories consistent with rationality.

11

Hence, a country’s continuation value Vi is a function of G and R , and not of Ri; Rj; ;

and we can write that value as V (G ; R ), without the subscript i.

The remaining parts of the theorem are best understood after the analysis of each

scenario and by following the proofs in the appendix. For example, in every scenario, the

value of another unit of technology is that each of the n countries can invest qR =n units

less in the following period: this explains the level @U=@R and why this is constant across

scenarios. The fact that U is linear in all stocks hinges on the linear investment costs,

revealing the power of this assumption. The linearity of V makes the model tractable and

permits only one equilibrium. To simplify notation, equations often rely on the conven-

tional de…nitions UG @U=@G , UR @U=@R , B 0 dB (yi ) =dyi , C 0 dC (G) =dG,

etc.

If investments as well as emissions were contractible, the countries would agree to the

…rst-best outcome. This follows from the observation (made in the previous subsection)

that the bargaining game is symmetric, even if the Ri s or the y i s di¤er. The outcome is

thus e¢ cient and coincides with the case in which a benevolent planner makes all decisions

in order to maximize the sum of utilities.

For future reference, we start by describing the …rst-best outcome, i.e., the outcome if

every gi;t and ri;t were contractible or chosen by a planner maximizing the sum of utilities

P

N Ui;t .

B 0 (gi (R ) + Ri ) = (1 qR ) K: (3.2)

C 0 (G ) = (1 qG ) (1 qR ) K=n: (3.3)

12

Part (1) simply states that, at the emission stage, the (private) marginal bene…t of

consumption should equal the (social) cost of pollution. Intuitively, this requires identical

consumption levels, yi = yj 8i; j 2 N 2 , regardless of the di¤erences in technologies.

Technological di¤erences do imply, however, that the ex post …rst-best emission level

should be smaller for i if Ri is large:

gi (R) yi Ri :

Part (2) states that the …rst-best investment level equalizes the marginal bene…t to the

marginal cost, recognizing that more investments today reduce the need to invest in the

next period. By substituting (3.2) in (3.1), we …nd the …rst-best pollution level, stated in

part (3). Interestingly, note that both yi and G are independent of the past stocks: G

P

is pinned down by (3.3) and, together with G , this pins down N gi . Since yi is pinned

down by (3.2), Ri = yi gi follows as a residual, and so does ri = Ri qR Ri; .

Expectations are w.r.t. the unknown realization of . Combined with (2.1), (3.3) pins

P

down the i gi s. Given the gi s, (3.2) determines the …rst-best Ri s which, with (2.2),

determine the …rst-best ri s. Throughout the analysis, we assume gi 0 and ri 0 never

bind.11

Note that, under (Q), the equations above can give us explicit solutions:

(i) The …rst-best emission levels are functions of the technology stocks, R fR1 ; :::; Rn g:

cn (ny + qG G + R) + qG (1 qR ) K

gi (R) = y i Ri . (3.4)

b + cn2

(ii) The symmetric …rst-best investments are:

qR qG 1 qG 1

ri = y R + G (1 qR ) + K:

n n cn2 b

(iii) Combined, the …rst-best pollution stock is:

X (1 qG ) (1 qR ) b

G = gi (R ) + qG G = K+ : (3.5)

i2N

cn b + cn2

The dynamics are noteworthy. If the random pollution shock t happens to be large,

the emissions are reduced somewhat but the total stock, Gt , is nevertheless increasing in

11

This is satis…ed if gi < 0 and ri < 0 are allowed, or if qG and qR are su¢ ciently small.

13

t. In the following period, the countries’investments are so much larger, and the optimal

emission levels are thus so much smaller, that the stock Gt+1 returns to the original level

(independent of t ). Since the large technology stock survives to period t + 2, investments

are then reduced. The steady state is reached after two periods–thanks to the linear

investment cost:12

Corollary 1. In the …rst-best outcome, a large t reduces gt and gt+1 but raises rt+1 :

= and = qG (1 )= = , where

@ t @ t @ t qR @ t

cn

2 (0; 1) :

b + cn2

In the other extreme scenario, neither emissions nor investments are negotiated. This may

be reasonable if the countries cannot commit to future policies because e¤ective sanctions

are lacking. This noncooperative situation is referred to as "business as usual."

Note that choosing gi is equivalent to choosing yi , once the Ri s are sunk. Substituting

(2.3) into (2.1), we get:

X

G = qG G + + yi R, (3.6)

i

X X

R Ri = qR R + ri D. (3.7)

i i

This way, the Ri s are eliminated from the model: they are payo¤-irrelevant as long as

R is given, and i’s Markov Perfect strategy for yi is thus not conditioned on them.13 A

country’s continuation value Ui is thus a function of G and R , not Ri; Rj; , and we

can therefore write it as U (G ; R ), without the subscript i.

12

With linear contribution costs, it is a typical result that an MPE can reach the steady state in a

single step; see Dockner et al. (1996). Also my model would feature a one-step transition with shocks

in the technology stock. However, as described by my corollaries, with a pollution stock (and nonlinear

emission bene…ts) as well as technology stocks, the transition lasts two periods when the shock regards

the pollution. If investment costs were convex, the transition would be more gradual (and reasonable).

13

This follows from the de…nition by Maskin and Tirole (2001, p. 202), where Markov strategies are

measurable with respect to the coarsest partition of histories consistent with rationality.

14

At the emission stage, when the technologies are sunk, i solves

yi

B0 C 0 + UG = 0: (3.8)

First, note that, since (3.8) decreases in gi , each country pollutes too much compared

to the …rst best (3.4) when UG < 0: a country is not internalizing the cost for the others.

Second, (3.8) con…rms that each i chooses the same yi , no matter the Ri s. While

perhaps surprising at …rst, the intuition is straightforward. Every country has the same

preference (and marginal utility) w.r.t. yi , and the marginal impact on G is also the same

for every country: one more energy unit generates one unit of emissions.14

Substituting (3.6) in (3.8) implies that a larger R must increase every yi . This implies

that if Ri increases but Rj , j 6= i, is constant, then gj = yj Rj must increase. Further-

more, substituting (2.3) in (3.8) implies that if Ri increases, gi must decrease. In sum: if

country i has better technology, i pollutes less but (because of this) other countries pollute

more. Clearly, this e¤ect discourages countries from investing. In addition, the Appendix

shows that, in equilibrium, ri increases in G but decreases in R . Thus, a country may

want to pollute a lot and invest little today in order to induce the other countries to invest

more tomorrow. With these dynamic e¤ects, this common pool problem is more severe

than its static counterpart (or the open-loop equilibrium).15

Proposition 1: There is a unique symmetric MPE. Countries pollute too much and

invest too little. Furthermore:

14

Obviously, this would not necessarily be true if I instead had focused on technologies that reduce the

emission factor of each produced unit (as do Dutta and Radner, 2004). The additive form (2.3) is chosen

not only because it simpli…es the analysis tremendously, but also because the resulting crowding-out

e¤ects might be reasonable in reality.

15

This is also the case in Ploeg and de Zeeuw (1991), for example.

15

Conveniently, the continuation value U is linear in G and R : Thus, the n + 1

stocks collapse to one, making the analysis tractable. This is thanks to (2.3) and the

linear investment cost, which also ensures that the equilibrium is unique.16 Note that the

equilibrium is also stationary.

The dynamic paths are simple. Following a large , every country pollutes less and,

in the next period, investments increase such that G+ returns to the original level. The

steady state is thus reached in one period.

The size of the externality e has no e¤ect, given D. Since only R matters for utilities

and strategies, Ri becomes a pure public good.17

For a given R, countries pollute more if qR is large and K=D small. Intuitively, if the

technology is e¢ cient, cheap, and long-lasting, one can pollute more today and let this

motivate investments in technology tomorrow. This, and other comparative statics can

be observed in the Appendix, which derives explicit formulae for the case where B (:) and

C (:) are quadratic functions.

We can get more speci…c solutions. By di¤erentiating (3.8) and abstracting from

uncertainty:

given R, :

B 0 (yino ) = C 0 UG : (3.10)

C 00 (n 1) B 00

@gino =@Ri = < 0;

nC 00 B 00

C 00

@gjno =@Ri = > 0 8j 6= i;

nC 00 B 00

16

As the proposition states, this is the unique symmetric MPE. Since the investment cost is linear,

there also exist asymmetric MPEs in which the countries invest di¤erent amounts. Asymmetric equilibria

may not be reasonable when countries are homogeneous, and they would cease to exist if the investment

cost were convex. Multiple equilibria never arise under long-term agreements.

17

Thus, adding to the public good G (by reducing gi ) or to R (by increasing ri ) has somewhat

similar e¤ects. However, they are not equivalent since a larger ri reduces emissions in every future

period. Increasing ri thus has longer-lasting impact than reducing gi , which is why ri is referred to as an

investment. Moreover, the remainder of this section lets gi be contractible while ri is not.

16

(3) Equilibrium investments are suboptimally low and ensure that:

0 nC 00 B 00

B (Rino + gino ) = (1 qR =n) K; (3.11)

C 00 B 00

" #

000 00 2 00 000 00

B (C ) =B C B

C 00 (n 1) B0: (3.12)

(C 00 B 00 ) (nC 00 B 00 )

(5) The resulting pollution level is suboptimally large and given by:

(n qR ) C 00

C 0 (Gno ) = (1 qG ) (1 qR ) K=n + 1 + (1 1=n) K (3.13)

C 00 B 00

Compared to the …rst-best (3.2), the right-hand side of (7.9) is larger. This implies that

country i’s consumption, Rino + gi , is smaller than at the …rst-best. Since Proposition 2

states that consumption levels are suboptimally large, given R, it follows that investments

must be suboptimally small: gino (Rno ) + Rino < gi (R ) + Ri and gi (Rno ) > gi (Rno )

implies Rno < R . Furthermore, the e¤ect of suboptimally small investments dominate

the suboptimally large emissions, leading to lower equilibrium consumption than at the

…rst-best.18

Part (2) …rst states that, if the technology stock is small today, every country invests

more in the next period. Naturally, this contributes to explaining the underinvestment

result. Second, if the pollution level is large, all countries invest more. This contributes

to explaining the suboptimally large emissions, as described by Proposition 2. Part (3)

states that, when all these e¤ects are taken into account, the resulting pollution level is

larger than the …rst-best level.

18

Note the qualifying second-order condition, which is violated if C 000 is positive and large and/or if

000

B is very negative. In both situations, an increase in R raises yj at a decreasing rate. Thus, the

discouragement e¤ect when i invests (i.e., the fact that other countries pollute more) is reduced when i

invests more, and this implies that an interior solution for ri may not exist. However, the second-order

condition holds if C 000 and B 000 are small relative to C 00 and B 00 ; and it always holds for quadratic

functions (implying C 000 = B 000 = 0).

17

Figure 3.1: The timing for short-term agreements.

With (Q) under business as usual, countries pollute too much and invest too little:

qR qG

ribau = y R + G

" n n #

2

(b + cn) qR qG

e (n 1) + 1 K (1 qR ) 2 K

cb (b + c) n n cn

< ri ;

c (ny + qG G + R) + qG (1 qR ) K=n

gibau Rbau = yi Ri

b + cn

> gi Rbau > gi (R ) : (3.14)

bau

= c= (b + cn) < .

If countries can commit to the immediate but not the distant future, they may negotiate

a "short-term agreement." If the agreement is truly short-term, it is di¢ cult for the coun-

tries to develop new technology during the time-span of the agreement and the relevant

technology is given by historic investments. This interpretation of short-term agreements

can be captured by the timing of Figure 2.

Negotiating the gi s is equivalent to negotiating the yi s as long as the Ri s are sunk and

observable (even if they are not veri…able). Just as in the previous section, (3.6)-(3.7)

imply that the Ri s are payo¤-irrelevant, given R. Even if countries have di¤erent Ri s,

18

they face the same marginal bene…ts and costs of yi whether negotiations succeed or not.

Symmetry thus implies that yi is the same for every country in the bargaining outcome.

E¢ ciency implies that the yi s are optimal (all countries agree on this):

B0 nC 0 + n UG = 0 ) (3.15)

gist = gi ;

where both gi and gist are functions of existing technology and pollution levels.

Substituting (3.6) in (3.15) and (2.3) in (3.15) implies that if Ri increases, gi must

decrease - but gj increases, 8j 6= i. Intuitively, if i has better technology, i’s marginal

bene…t from polluting is less (and i is also polluting less in equilibrium). This gives i a

poor bargaining position, and the other countries can o¤er i a smaller emission quota.

At the same time, the other countries negotiate larger quotas for themselves, since the

smaller gi (and the smaller G) reduce the marginal cost of polluting. Anticipating this

hold-up problem, every country is discouraged from investing. The Appendix shows i

invests until

K (n qR )

EB 0 gi + Rist = ; (3.16)

D

so Rist is smaller than the optimal one, given by (3.2). The equilibrium pollution level is

(1 qG ) (1 qR ) K K (1 1=n)

EC 0 (G) = + :

Dn D

Thus, although emission levels are ex post optimal (3.15), once the investments are sunk,

G is larger compared to its …rst-best level (3.3) since the hold-up problem discourages

investments and makes it ex post optimal to pollute more.

Countries pollute too much and invest too little. Furthermore:

19

While its intuition is quite di¤erent, Proposition 2 is identical to Proposition 1. In

particular, UG and UR are exactly the same as in the noncooperative case. This does not

imply that U itself is identical in the two cases: its level can be di¤erent. But this does

imply that in deriving actions and utilities for one period, it is irrelevant whether there

will also be a short-term agreement in the next (or any future) period. This makes it

convenient to compare short-term agreements to no agreement.

Pollution is less under short-term agreements compared to no agreement. That may not

be surprising, since the very motivation for negotiating is to reduce pollution. But what

about equilibrium investments and utilities?

Unfortunately, a general comparison is not feasible. But some insight can be generated

by assuming B 00 (:) and C 00 (:) are constants as in Q.

Proposition 3: Under (Q), short-term agreements reduce (i) pollution, (ii) investments,

and (iii) utilities if n is large and each period short (i.e., if (3.17) holds):

K n 1 qR

EGst = EGno 1 ;

D b+c n

K (n 1)2 qR

rist = rino 1 ;

nD2 (b + c) n

" #

(b + c) (bcnD=K)2

(n 1)2 (1 q R )2 > 2

: (3.17)

(b + cn2 ) (b + cn)2

Rather than being encouraging, short-term agreements impair the motivation to invest.

The reason is the following. Anticipating negotiations, the hold-up problem is exactly as

strong as the crowding-out problem in the noncooperative equilibrium: in either case, each

country only enjoys 1=n of the total bene…ts generated by its investments (no matter e).

In addition, when an agreement is expected, i understands that pollution will be reduced.

A further decline in emissions, made possible by new technology, is then less valuable.

Hence, each country invests less.19

19

A counter-argument is that, if an agreement is expected, it becomes more important to invest to

ensure a decent energy consumption level. While this force is smaller under (Q), it could dominate for

other functional forms.

20

Since investments decrease under short-term agreements, utilities can decrease as well.

This is the case, in particular, if the period for which the agreement lasts is truly short.

If so, and qR are large, while there is not much uncertainty from one period to the

next. All changes make (3.17) reasonable, and it always holds when the agreement is very

short ( ! 0). Moreover, (3.17) is more likely to hold if n is large (it always holds if

n ! 1): the under-investment problem is then large, it becomes important to increase

investments, and this is achieved by having no agreement.

At the emission stage, however, once the investments are sunk, all countries bene…t

from negotiating an agreement. It is the anticipation of negotiations which reduces in-

vestments and perhaps utility. Thus, if (3.17) holds, the countries would have been better

o¤ if they could commit to not negotiate short-term agreements. In particular, it may be

better to commit to emission levels before the investments occur.

The model can (and will) be used to analyze agreements of any length. If the countries can

negotiate and commit to future emission levels, it will be possible to develop technologies

within the time-frame of an agreement. The other countries are then unable to hold up

the investing country, since the quotas have already been negotiated, at least for the near

future.

countries negotiate the gi s in the beginning of each period, before the investments are

made. While these agreements last only one period, they are indeed "longer" than the

short-term agreements studied in Section 4.2. Moreover, each period can be arbitrarily

long in the model, since I have not speci…ed whether the discount factor, for example, is

large or small.

For each period, the timing is now reversed. When investing, a country prefers a larger

stock of technology if its quota, gilt , is small, since otherwise it is going to be very costly

21

Figure 3.2: The timing for long-term agreements.

to comply. Consequently, ri decreases in gilt . The Appendix shows that ri increases until

K (1 qR =n)

B 0 gilt + Rilt = : (3.18)

D e (n 1)

Compared to (3.16), (3.18) suggests that countries invest more under long-term than

under short-term agreements (at least for the same gi ). But compared to the …rst best

(3.2), countries still under-invest if e > 0 or qR > 0. First, a country does not internalize

the spillover e on the other countries. Second, if the agreement does not last forever

( > 0), a country anticipates that good technology worsen its bargaining position in the

future, once a new agreement is to be negotiated. At that stage, good technology leads

lt

to a lower gi;+ since the other countries can hold up i when it is cheap for i to reduce its

emissions.20 This discourages i from investing now, particularly if the current agreement

is relatively short ( large) and the technology likely to survive (qR large). In sum, if e,

, and qR are large, it is important to encourage more investments. This can be achieved

by a small gilt .

The Appendix shows that the equilibrium and optimal gilt s must satisfy (3.3): the

equilibrium pollution level is similar to the …rst best! But since (3.18) implies that the

equilibrium Rilt s are less than optimal, the gilt s are suboptimally low ex post. Combining

(3.3) and (3.18):

K e(1 qR )(n 1) + qR (1 1=n)

B0 EnC 0 n UG = ) (3.19)

D D e (n 1)

K e(1 qR )(n 1) + qR (1 1=n)

gilt = Egi if (Q).

D (b + cn2 ) D e (n 1)

20

Or, if no agreement is expected in the future, a large Ri;+ reduces gi;+ and increases gj;+ , as proven

in Section 4.1.

22

Taking the investments as given, optimally the gilt should have satis…ed B 0 EnC 0

n UG = 0 rather than (3.19). Only that would equalize marginal costs and bene…ts

of abatement. Relative to this ex post optimal level, the gilt satisfying (3.19) must be

lower. If e and are large, the right-hand side of (3.19) is large, and gi must decline.

This makes the long-term agreement more demanding or tougher to satisfy at the emis-

sion stage. The purpose of such an overambitious agreement is to encourage investments,

since these are suboptimally low when e and are large.

Proposition 4: (i) There is a unique MPE. (ii) Each country invests more if the agree-

ment is tough (3.18). Therefore, (iii) the optimal agreement (3.19) is tougher if the

externality e is large and the time horizon short ( large).

On the other hand, if e = qR = 0, the right-hand side of (3.19) is zero, meaning that

the commitments under the best long-term agreement also maximize the expected utility

ex post. In this case, there are no externalities, and the countries are not concerned with

how current technologies a¤ect future bargaining power. Thus, investments are …rst best

and there is no need to distort the gilt s downwards.

The continuation value U is linear in the stocks, making the analysis tractable. More-

over, URlt = qR K=Dn and UGlt = qG (1 qR ) K=Dn, just as in the two previous subsec-

tions. The predicted contract and investments are therefore robust to whether there is a

long-term agreement, a short-term agreement, or no agreement in the subsequent period.

Assume now that at the beginning of period 1, countries negotiate the gi;t s for every

period t 2 f1; 2; :::; T g. When investing in period t 2 f1; 2; :::; T g, countries take the gi;t s

as given, and the continuation value in period T + 1 is U (GT ; RT ). At the last investment

stage, i’s problem is the same as before and i invests until (3.18) holds. Anticipating this,

i can invest less in period T by investing more in period T 1. The net investment cost

is thus K (1 qR ). The same logic applies to every previous period and, in equilibrium,

K (1 qR ) K (1 qR )

EB 0 (gi;t + Ri;t ) = = for t < T: (3.20)

d D e (n 1)

23

Thus, the incentives to invest are larger earlier than in the last period (3.18). In fact,

if e = 0, investments are …rst best for every t < T . In the last period, however, countries

invest less, anticipating the hold-up problem in period T + 1.21

All this is anticipated when the countries negotiate the gi;t s. As shown in the Appendix,

the optimal gi;t s must satisfy (3.3) for every t T : the pollution level is similar to the

…rst best! The gi;t s are thus lower than what is optimal ex post when e > 0 and countries

under-invest. Combining (3.3) and (3.20) for t < T ,

K e (n 1) (1 qR )

B0 EnC 0 n UG = ) (3.21)

D D e (n 1)

K e (n 1) (1 qR )

gi;t = Egi if (Q).

D (b + cn2 ) D e (n 1)

be smaller if e is positive and large. For t = T , however, (3.19) continues to hold and

since its right-hand side is less than that of (3.21), yi;T < yi;t for t < T . In words: in order

to encourage investments, the agreement should be tougher to satisfy toward the end.

Proposition 5: Suppose countries negotiate emission levels for T periods. (i) There is

a unique MPE. (ii) Investments decrease toward the end and, to encourage more invest-

ments, (iii) the equilibrium agreement becomes tougher over time compared to the ex post

optimum (3.19)-(3.21).

The optimal T trades o¤ two concerns. On the one hand, investments are particularly

low just before a new agreement is to be negotiated. This hold-up problem arises less

frequently if T is large. On the other hand, the stochastic makes it hard to predict the

optimal gi;t s for the future, particularly when T is large. If were known or contractible,

the agreement should last forever. Otherwise, one can show that the optimal T declines

as e # 0. The Appendix derives a large number of comparative statics for the case where

B and C are quadratic (Q):

21

Or, if no agreement is expected in period T + 1, i anticipates @gj;T +1 =@Ri > 0, j 6= i.

24

Proposition 6: (i) Under (Q), the optimal length is …nite, T < 1, if and only if:

2 2

K qR K bcqG

e+ e [2 qR ] + < :

n n qR (1 2

qG ) (1 qG2

) (n 1)2

Reinforcing this problem by a small T is then especially harmful, and the optimal T is

larger. Naturally, T should be smaller if future optimal emissions are uncertain ( large)

and important (c large).22

The long-term agreements above are not renegotiation-proof. Not only are the commit-

ments made before the severity of the problem (determined by ) is known, but they also

specify emission levels that are less than what is expected to be optimal ex post. The

countries may thus be tempted to renegotiate the treaty, after and the investments are

realized. This section derives equilibria when renegotiation is costless.

The timing in each period is now the following. First, the countries negotiate the initial

commitments, the gide s, referred to as "the default." If these negotiations fail, it is natural

to assume that the threat point is no agreement.23 Thereafter, the countries invest and

is realized. Before carrying out their commitments, the countries get together and

renegotiate the gide s. Relative to the threat point gide , the bargaining surplus is split

equally.24

Renegotiation ensures that emission levels are ex post optimal, in contrast to the long-

term agreements in Section 4.3. When investing, a country anticipates that it will not, in

22

If b is large, consuming energy is much more important than the concern for future bargaining power,

the hold-up problem vanishes, and the optimal T is smaller.

23

If the threat point were short-term agreements, negotiated after the investment stage, the outcome

would be identical.

24

If instead the threat point at the renegotiation stage were that the countries would get upset and

revert to no cooperation, the renegotiation game would be identical to negotiations under short-term

agreements, and the incentives to invest would be as discussed in Section 4.2.

25

the end, have to comply with an overambitious long-term agreement. Will this jeopardize

the incentives to invest?

Proposition 7: (i) There is a unique MPE. (ii) The initial agreement satis…es (3.22):

the initial quota gide is thus smaller if the spillover e is large and the time horizon short

( large). (iii) All investments and emissions are …rst best.

K

B 0 gide + Ri = ) (3.22)

D en

K en

gide = Egi + qR under (Q).

bD D en

When investing, the countries do anticipate that, after renegotiation, emissions will

be ex post optimal, just as they were under a short-term agreement. But for the short-

term agreement, countries with the poorest technology got the better deal, since these

countries were quite satis…ed with the (noncooperative) default outcome in which they

could pollute more. This made the "technology-losers" reluctant to negotiate, giving them

a better bargaining position. However, things are quite di¤erent when renegotiating an

ambitious agreement. Then, the technology-losers are desperate to reach a new agreement

that would replace the initial commitments. Such countries now have a poor bargaining

position, and they are, in equilibrium, going to get quite a bad deal (where they must pay

or accept a small gi ). Fearing this, the countries are induced to invest more, particularly

if the default emission levels are small.

All this will be taken into account when negotiating the initial agreement, the gide s.

The more ambitious this agreement is, the more the countries invest. This is desirable if

the countries are otherwise tempted to under-invest. Thus, the agreement should be more

ambitious if e and qR are large. Formally, (3.22) implies that gide decreases in e and qR

26

since Ri is increasing in qR but independent of e. Intuitively, if the length of the agreement

is short, countries fear that more technology today will hurt their bargaining position in

the near future. They thus invest less than what is optimal, unless the agreement is more

ambitious.25

Compared to (3.19), the initial agreement should be tougher than the optimal long-

term agreement (gide < gilt ). Intuitively, the long-term agreement (without renegotiation)

balances the concern for investments (by reducing gilt ) and for ex post e¢ ciency (in which

gi should be larger). The latter concern is irrelevant when renegotiation ensures ex post

optimality, so the initial contract can be tougher - indeed so tough that investments are

…rst best.

The …rst best is implemented by any long-term agreement lasting T 1 periods if rene-

de

gotiation is possible. Suppose an agreement speci…es gi;t , t 2 f1; :::; T g. Investments at

t < T are …rst best if:

K (1 qR ) K 1 qR

de

B 0 gi;t + Ri = de

) gi;t = Egi;t if (Q). (3.23)

D en bD D=en 1

de

Compared to (3.22), gi;t is larger when T > 1 than when T = 1 (Ri is independent

of T ). Thus, agreements lasting one period should be more ambitious than if T > 1,

con…rming the earlier …nding that an agreement should be more ambitious if its length is

short.

Proposition 8: Suppose countries negotiate emission levels for T > 1 periods and rene-

de

gotiation is possible. At t < T , all investment and emission levels are …rst best if gi;t is

de 0 26

given by (3.23). T and gi;t 0 , t > t, are irrelevant.

25

No contract can help if the externality dominates the direct e¤ect (e d), as …rst pointed out by

Che and Hausch (1999) and later generalized by Segal and Whinston (2002).

26 de 0

Since T and gi;t 0 , t > t, are irrelevant, the predictions are not sharp when renegotiation is feasible.

de

With a small …xed cost of negotiating each gi;t 0 , however, the unique optimal contract would be described

by Proposition 7.

27

3.5.3. Implementation

de

The optimal gi;t+1 s depend on t and they must be (re)negotiated after t is realized. But

de

instead of being negotiated at the start of period t + 1, the gi;t+1 s may equally well be

negotiated just before the emission stage in period t, since no information or individual

decisions are made in between. At this time, therefore, the countries may negotiate every

de de

gi;t+1 <Egi;t+1 while simultaneously renegotiating the gi;t s and replacing them by the

de

optimal gi;t+1 s, which are expected to be larger than the gi;t s negotiated in advance. This

might be observationally equivalent to a time-inconsistent policy where the countries make

ambitious plans for the future, while repeatedly backing down from promises made in the

past. But rather than verifying a time-inconsistency problem, this leads to the …rst best.

future but when the future arrives, they relax these promises. This procedure implements

the …rst best.

This section introduces a new externality, relates it to trade agreements and analyzes the

e¤ects of and for climate treaties.

Externalities: There are several ways in which spillovers could be formalized, but

many of them give similar results to those above.27 An alternative (or addition) to the

spillover above arises by assuming that j bene…ts directly by the externality xri when

i 6= j invests. If K continues to be the social net marginal investment cost, i’s private

investment cost is

k K + (n 1) x: (4.1)

X

ui = B (yi ) C (G) kri + xrj :

j6=i

27

For example, the spillover could be related to Ri rather than ri (as in Coe and Helpman, 1995). The

results would be similar, but i must then consider the impact of ri on Rj not only for the present, but

for all future periods.

28

The externality x can be interpreted as a general technological spillover (a¤ecting ui

and not only i’s environmental technology) or as a spillover that reduces i’s cost of making

P

a particular investment ri (such that the cost is kri xrj ).28 The Appendix allows for

both e and x and …nds them to play similar roles.

Trade in technologies: The externality x may re‡ect international law. Suppose

that ri has the potential of reducing j’s cost (or increasing uj ) by xri units. Of this, j can

copy a fraction 2 [0; 1] for free. The remaining fraction, 1 , is available if j pays i

for transferring (or licensing) its technology. If i sets the price, i charges j’s willingness to

pay, (1 ) x, for each invested unit. Clearly, the net externality for j is x = x. Weaker

intellectual property rights mean larger , x and k.

Firms: Private …rms have been ignored so far in the analysis. But since …rms may

develop most of the technology in reality, it is comforting to note that the results would

not necessarily change if …rms were introduced. If the government can perfectly regulate

the …rms’investments in technologies by specifying conditional fees or grants, then …rms

are perfect agents for the government and it is su¢ cient to consider the government’s in-

centives. Even without regulation, if the governments are outsourcing the development of

technology and …rms compete by setting prices, anticipating the revenues (n 1) (1 )x

when licensing to foreigners, technological units are provided at cost-price k and …rms are

not a¤ecting the game.

Tari¤s and subsidies: If the foreign individuals or …rms paying for the externality

(1 ) x face an ad valorem tari¤ , they are willing to pay only (1 ) (1 ) x for each

imported unit. On the other hand, since trade is veri…able, one may consider encouraging

R&D by subsidizing trade in abatement technology.29 Let s represent this subsidy, paid

for by either the importing country or uniformly by the non-exporting countries. In either

case, the net externality for country j when country i decides to invest becomes

x= x (s ) (1 ) x:

The private cost of investing faced by a country (or government) is k given by (4.1), just

28

In fact, the cost would take exactly this form if countries simultaneously choose their targets for the

Ri s and let the expenditures (the ri s) follow residually from (2.2) rather than vice versa.

29

Stern (2007, p. 398) states "There are two types of policy response to spillovers... enforcement of

private property rights through patenting [and] government funding."

29

as before. Thus, k and x are both higher with tari¤s, since the importing country is then

capturing more of the surplus, but lower if importers subsidize technological trade. The

role of s would be identical if directed to investments rather than the associated trade.

Proposition 9: If the subsidy ( s) is low, tari¤ ( ) high and the intellectual property

rights weak ( large), (i) the agreement should be tougher and more long-lasting while (ii)

short-term agreements are likely to be worse than no agreement under (Q).

While the proof is in the Appendix, the intuition is straightforward. With tari¤s, small

subsidies and weak property right protection, …rms do not capture the bene…t experienced

by the foreigners. This forces the government to pay more to compensate the …rms when

investing, and they invest less. A further reduction in investment is then particularly bad,

making short-term agreements worse than the noncooperative equilibrium (under (Q)).

To encourage more investments, it is better to negotiate an agreement that is tougher and

more long-lasting.

If s, or can be speci…ed by international law, one may ask what their levels should

be. Does the optimal subsidy, tari¤ and intellectual property right protection depend on

the climate treaty?

Proposition 10: s should be larger while and smaller if the agreement is short-

lasting. The optimal s, and are given by (4.2) for short-term agreements, (4.3) for

long-term agreements (and the last period of multiperiod agreements), and by (4.4) for

multiperiod agreements (except for the last period).

K

sst st

1 st st

= > (4.2)

nx

K en

slt lt

1 lt lt

= qR + (1 qR ) > (4.3)

nx D

Ke

st t

1 t t

= : (4.4)

xD

It is more important to encourage investments by protecting intellectual property

rights, subsidizing technological trade and reducing tari¤s if the climate treaty is short-

lasting, since the hold-up problem is then larger. Such "trade agreements" are thus

strategic substitutes to climate treaties: Weakening cooperation on one area makes further

cooperation on the other more important.

30

If the subsidy can be freely chosen, short-term agreements are …rst best: while (4.2)

induces optimal investments, countries are negotiating the ex post optimal emissions. The

emission levels under long-term agreements (without renegotiation) are never …rst best,

however, due to the stochastic .

Corollary 4: If s can be freely chosen, short-term agreements are …rst best while long-

term agreements (without renegotiation) are not.

If renegotiation is possible, the …rst best is feasible no matter s, and as long as the

initial agreement is more ambitious for large e and x (and thus large and but small

s). Under (Q), the gide s should satisfy30

K x=K + e=D

gide = Egi + qR : (4.5)

bD 1=n e=D

If the gide s are exogenously given and high (e.g. because a tough climate treaty would

be impossible to enforce), e¢ ciency and (4.5) are still ful…lled if just x is su¢ ciently

small (requiring a large s and small or ). This suggests that less ambitious climate

treaties should be accompanied by technological subsidies, low tari¤s and property right

protection, con…rming that the two types of agreements are strategic substitutes.

Corollary 5: With renegotiation, the …rst best is implemented even if gide increases, if

just s increases or or decreases.

think through these, and re‡ect on how the results may change if one instead make other

assumptions.

At the same time, a few assumptions as quite innocent, and can easily be relaxed. We

may consider two of these that are particularly relevant.

30

The general conditions are derived in the Appendix.

31

5.1. Tradable Permits

To simplify intuition and the reasoning, it has been assumed that quotas cannot be traded.

This is not a critical assumption, however.

Proposition 11: (i) All results survive with tradable permits, no matter whether side

payments are available. (ii) The equilibrium and optimal permit price is B 0 , thus increas-

ing in e and larger if T = 1 than if T > 1.

B 0 (gi + Ri ) is the value of being allowed to pollute one more unit, keeping G and R

constant. Proposition 11 follows by noting that, …rst, there is never any trade in permits

in equilibrium. Hence, if i invests as above, the marginal bene…t of more technology is

the same. Second, if i deviated by investing more (less), it’s marginal utility of a higher

technology decreases (increases) not only when permit-trade is prohibited, but also when

trade is allowed since more (less) technology decreases (increases) the demand for permits

and thus the equilibrium price. Hence, such a deviation is not attractive. When permits

are tradable, altering their allocation is a form of side transfer, making the feasibility of

explicit transfers irrelevant.31;32

5.2. Heterogeneity

So far, countries have been completely symmetric and there has been no heterogeneity. It

did turn out, however, that for a given R , di¤erences in Ri; (such as Ri; Rj; ) were

payo¤-irrelevant. It is therefore not necessary to assume that all countries start out with

the same technology.

Moreover, since the continuation values are linear in R, countries are risk-neutral in

that it would not matter if qR were random, as long as the expected depreciation rate is

1 qR . The realized depreciation can also be di¤erent for every country, as long as the

expected depreciation rate is 1 qR for everyone.

31

In a two-stage model, also Golombek and Hoel (2005) …nd that the permit price should be higher

than "the Pigouvian" level to induce R&D when there are spillovers.

32

An earlier version of this paper analyzed emission taxes and derived similar results: for example, the

…rst best is feasible with renegotiation if the initial tax is higher than what is expected to be optimal ex

post, particularly if the spillover is large and the agreement’s length relatively short.

32

A strong assumption has been that all countries had identical preferences. With

quadratic utility functions, for example, it is reasonable to assume that countries have

di¤erent bliss points (y i ) for energy consumption. Generalizing the quadratic speci…cation,

we may write the bene…t function as B (yi y i ), where y i is a country-speci…c reference

point (not necessarily bliss). Recognizing the importance of such heterogeneity, all proofs

allow the reference point y i to vary. While a large y i increases the equilibrium gi , the

comparative statics are unchanged.33

Proposition 12: All results continue to hold with heterogenous bliss or reference points

in B (yi y i ).

6. Further Readings

These lectures notes mostly draw on Harstad (2012 and 2015). But by analyzing environ-

mental agreements as incomplete contracts in a dynamic game, we relate to three strands

of literature.

The literature on climate policy and environmental agreements is growing.34 While

Nordhaus (2006) criticizes the Kyoto Protocol for not being su¢ ciently inclusive, cost

e¤ective, or ambitious, the current paper demonstrates that, even without these weak-

nesses, this type of emission agreement is fundamentally ‡awed. The literature usually

emphasizes the positive e¤ects of regulation on technological change.35 With technolog-

ical spillovers, it has been recognized that as a second-best, the climate policy should

33

Other types of heterogeneity would be harder to analyze. For example, suppose the cost of developing

technology, K, varied across countries. In equilibrium, only countries with a small K would invest. This

would also be optimal, but, just as before, the investing countries would invest too little. In a long-term

agreement, one could encourage these countries to invest more by reducing gilt or, if renegotiation is

possible, gide . Such small gi s would not be necessary (or optimal) for noninvesting countries. Naturally,

the investing countries would require some compensation to accept the optimal emission targets. At the

same time, a small gi would not motivate i to invest if i were allowed to purchase permits from noninvesting

countries with higher gj s. Thus, with heterogeneity in investment costs, it matters a great deal whether

side transfers are possible and permits tradable: Proposition 11 would be false if such heterogeneity were

introduced. Evaluating political instruments under heterogeneity is thus an important task for future

research.

34

See Kolstad and Toman (2005) on climate policy and Barrett (2005) on environmental agreements.

Aldy et al. (2003) and Aldy and Stavins (2007; 2009) discuss alternative climate agreement designs.

35

See, e.g., Ja¤e et al. (2003) or Newell et al. (2006).

33

be more ambitious to encourage investments (Golombek and Hoel, 2005; Hart, 2007;

Greaker and Pade, 2009). With regards to the term of the agreement, a typical recom-

mendation is a decade-long agreement, partly to ensure ‡exibility (see, for example, Karp

and Zhao, 2009). The present note, in contrast, shows that short-term agreements reduce

the incentive to invest in new technology and can be worse than business as usual. This

result builds on Buchholtz and Konrad (1994), who …rst noted that R&D might decrease

prior to negotiations.36 Beccherle and Tirole (2011) have recently analyzed a related one-

period model and shown that anticipating negotiations can also have adverse e¤ects if

the countries, instead of investing, sell permits on the forward market, allow banking,

or set production standards. Helm and Schmidt (2014) have endogenized the coalition

size, while Schmidt and Strausz (2014) focus on when cooperation is feasible without side

payments if countries are heterogeneous. With only one or two period, however, all these

models miss important dynamic e¤ects and thus the consequences for agreement design.

By allowing agreements on quantities or emissions, but not on e¤ort or investments,

we follow the literature on incomplete contracts (surveyed by Segal and Whinston, 2013).

With long-term commitments one may point to "the di¢ culty of foreseeing all possible

later contingencies that might arise" (Maskin and Tirole, 1988:550). With such uncer-

tainty, Harris and Holmstrom (1987) discuss the optimal length when contracts are costly

to rewrite. To preserve the optimal incentives to invest, Guriev and Kvasov (2005) argue

that the agents should continuously renegotiate the length. Ellman (2006) studies the

optimal probability for continuing the contract and …nds that this probability should be

larger if speci…c investments are important. This is somewhat related to the result that

the optimal term should be long if intellectual property rights are weak.

A third related literature is that on dynamic games with stocks. Since the evolving

stock typically in‡uences the incentive to contribute, the natural equilibrium concept is

Markov perfect equilibrium and it is quite standard to assume linear-quadratic functional

36

Analogously, Gatsios and Karp (1992) show how …rms may invest suboptimally prior to merger

negotiations. For climate policy, Hoel and de Zeeuw (2010) show that R&D can decrease if countries

cooperate because they then reduce pollution even without new technology; note, however, that there is no

negotiation in their model and their analysis hinges on a "breakthrough technology" and binary abatement

levels. In contrast, Muuls (2009) …nds that investments increase when negotiations are anticipated.

Açikgöz and Benchekroun (2014) discuss similar e¤ects regarding abatements prior to an agreement.

34

forms.37 Calvo and Rubio (2013) provide a nice survey of the applications to environmen-

tal agreements. The closest papers to these notes are probably Dutta and Radner (2004,

2009, and 2012). In these papers, the environmental harm from pollution is linear in the

stock, so the pollution stock does not play the same strategic role as in the present model.

Furthermore, Dutta and Radner mostly focus on equilibrium selection and do not study

incomplete contracts, which is the focus here.

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Aldy, Joseph and Stavins, Robert (Ed.) (2007): Architectures for Agreement: Addressing

Global Climate Change in the Post-Kyoto World. Cambridge U. Press.

Barrett, Scott (2005): “The Theory of International Environmental Agreements,”Hand-

book of Environmental Economics 3, edited by K.-G. Mäler and J.R. Vincent.

Barrett, Scott and Stavins, Robert (2003): "Increasing Participation and Compliance

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Battaglini, Marco, and Coate, Stephen (2007): "Ine¢ ciency in Legislative Policymaking:

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Beccherle, Julien and Tirole, Jean (2010): "Regional Initiatives and the Cost of Delaying

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Buchholz, Wolfgang and Konrad, Kai (1994): "Global Environmental Problems and the

Strategic Choice of Technology," Journal of Economics 60 (3): 299-321.

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37

For a comprehensive overview, see Engwerda (2005).

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Che, Yeon-Koo and Sakovics, Jozsef (2004): "A Dynamic Theory of Holdup," Economet-

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Chung, Tai-Yeong (1991): "Incomplete Contracts, Speci…c Investment, and Risk Sharing,"

Review of Economic Studies 58 (5): 1031-42.

Coe, David T. and Helpman, Elhanan (1995): "International R&D spillovers," European

Economic Review 39 (5): 859-87.

d’Aspremont, Claude and Jacquemin, Alexis (1988): "Cooperative and Noncooperative

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Di¤erential Games in Economics and Management Science, Cambridge U. Press.

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39

7. Proofs

All propositions are here proven with the generalizations discussed in Sections 5-6: the

value of yi is given by the increasing and concave function (yi y i ), countries can have

di¤erent reference points y i , and ri generates a direct externality x = s= (n 1) on

j 6= i in addition to the technological spillover e:

X

ui = (yi yi) C (G) kri + x rj :

j6=i

While Ui is the continuation value just before the investment stage, let Wi represent the

(interrim) continuation value at (or just before) the emission stage. To shorten equations,

use m @Ui =@G , z e

@Ui =@R , R e

qR R , G qG G + and yei yi + y yi,

where y is the average y i : Note that by substitution,

X X X

G = G e+ yi Ri = qg G + yei R; and

i i i

X X

ui = B (yi yi) C (G) kri + x rj = B (e

yi y) C (G) kri + x rj :

All i’s are identical w.r.t. yei . The game is thus symmetric, no matter di¤erences in Ri

or y i , and the payo¤ relevant states are G and R. Analyzing the symmetric equilibrium

(where symmetric countries invest identical amounts), I drop the subscript for i on U and

W . The proof for the …rst best (3.4)-(3.3) is omitted since it would follow the same lines

as the following proof.

0

0 = (yi yi) C 0 (G) + UG (G; R)

X X

= 0

(e

yi y) C0 G e R+ e

yei + UG (G R+ yei ; R); (7.1)

implying that all yei s are identical and implicit functions of G

ment stage, i maximizes:

!

X

e R)

EW (G; kri = EW e+

qG G + ; R Dri kri , (7.2)

i

40

implying that R is going to be a function of G , given implicitly by E@W (qG G +

; R)=@R = k=D and explicitly by, say, R(G ). In the symmetric equilibrium, each

country invests (R(G ) qR R ) =Dn. Thus:

R(G ) qR R

U (G ; R ) = EW (qG G + ; R(G )) (k (n 1) x) )

Dn

@U qR K

z= = (7.3)

@R Dn

in every period. Hence, URG = UGR = 0, m and UG cannot be functions of R and (7.1)

implies that yei , G and thus (e

yi y) C (G) e

(:) are functions of G R only. Hence,

e

write G G R . (7.2) rewritten:

. This gives @ri =@G = qG =Dn and U becomes:

U (G ; R ) = E ( + ) Kr + U (G ( + ) ; R)

qG G qR R

= E ( + ) K + U (G ( + ) ; qG G ))

Dn

qG KqG

m= = @U=@G = K + U R qG = (1 qR ) ; (7.4)

Dn Dn

since G ( + ) and (:) are not functions of G when qG G R = : Since UG is

a constant, (7.1) implies that if R increases, yei increases but G must decrease. Thus,

yi =@R 2 (0; 1), so @gi =@Rj = @ (e

@e yi yi + y Ri ) =@Rj > 0 if i 6= j and < 0 if i = j.

Under (Q), (7.1) becomes

m + cG

0 = cG + by i byi m ) yi = y i : (7.5)

b

X m + cG X

G = (yj e=G

Rj ) + G e+n y Rj )

j

b j

byn e

mn + b G R

G = , so (7.6)

b + cn

0 1

e e

m c @ byn mn + b G R

A = (y i

by m c G R

yi = y i y) + and

b b b + cn b + cn

e P

by m c G j6=i Rj Ri (b + cn c)

gi = y i Ri = (y i y) + :

b + cn b + cn

41

Interrim utility (after investments are sunk) can be written as:

(by)2 m2

Wino c (1 + c=b) G =2 Gmc=b + 2

+ U (G; R): Thus,

2b

b bm (1 + c=b)

@Wino =@R = c (1 + c=b) G + + z: (7.7)

b + cn b + cn

At the investment stage, each country sets k=D =E@Wino =@R. From (7.7):

b+c m (b + c)

k=D = Ec (G) + +z )

b + cn b + cn

k (b + cn) m z b + cn

EG = , combined with (7.6): (7.8)

cD (b + c) c c b+c

b + cn

R = qG G + ny nm=b EG

b

k (b + cn)2 z (b + cn)2 m

= qG G + yn + + ) (7.9)

Dcb (b + c) cb (b + c) c

k (b + cn)2 z (b + cn)2 m

ri nD = qR R + q G G + yn + + :

Dcb (b + c) cb (b + c) c

e = qG G + , (7.6) gives G =EG + b= (b + cn) : Substituting in (7.5) and (7.8):

Since G

m + cG (k=D z) (b + cn) c

yi = y i = yi :

b b (b + c) b + cn

This is helpful when calculating uno

i :

2 2

c k (b + cn) m z (b + cn) b b (k=D z) (b + cn) bc

uno

i = + +

2 Dc (b + c) c c (b + c) b + cn 2 b (b + c) b (b + cn)

!

K e + qG G k (b + cn)2 z (b + cn)2 m

R + yn + + )

Dn Dcb (b + c) cb (b + c) c

2 2

1 k b + cn 1 1 m2 m b + cn k

Euno

i = z + + z

2 D b+c c b 2c c b+c D

!

K e (b + cn)2 k m bc (b + c) 2

qG G R z + yn + :

Dn bc (b + c) D c 2 (b + cn)2

At the emission stage, the countries negotiate the gi s. gi determines yei , and since countries

have symmetric preferences over yei (in the negotiations as well as in the default outcome)

the yei s must be identical in the bargaining outcome and e¢ ciency (7.1) requires:

X X

0= 0

(e

yi y) =n e

C0 G R+ e

yei + UG (G R+ yei ; R): (7.10)

42

The rest of the previous proof continues to hold: R will be a function of G only, so

e

UR = qR K=Dn. This makes EG R a constant and UG = qG (1 qR ) K=Dn, just

as before. The comparative static becomes the same, but the levels of gi , yi , ri , ui and Ui

are obviously di¤erent from the previous case.

The envelope theorem can be used to calculate equilibrium investments:

" #

1 X

max E max yj y) C (G) + U (G; R)

(e kri )

ri n feyj g j

EC 0 (G) D E UG D + E UR D k =

(1 qG ) (1 qR ) K (K + xn) (1 1=n) E 0 (e

yi y)

+ = + UG )

Dn D n

0

(n qR ) K n (n 1) x E (e yi y)

+ = :

D D n

Under (Q), the …rst-order conditions for the optimal yei s:

nm + ncG

0 = ncG + by be

yi nm ) yei = y :

b

X nm + ncG

G = (yj e=G

Rj ) + G e+n y R) (7.11)

j

b

byn e

mn2 + b G R

G = , so (7.12)

b + cn2

by mn e

cn G R

yi = y i y+ and

b + cn2

by mn e

cn G R

gi = y i y+ Ri :

b + cn2

Interrim utility is

2

c 2 b nm + ncG

=Wist G + U (G; R) , so

2 2 b

st

@Wi =@R = cG + m + z:

k m+z

k = D (EcG + m + z) ) EG = : (7.13)

cD c

43

Subsituting in (7.11), after taking the expection of it, and solving for R gives

m b + cn2 k z

R = qG G + ny + : (7.14)

c b cD c

From (7.12) and (7.13):

k m+z b

G = + ) (7.15)

cD c b + cn2

nm nc k m+z b n k bc

y yei = + + 2

= z+ )

b b cD c b + cn b D b + cn2

c 2 b

ust

i = G (y yei )2 Kr

2 2

2 2

c k m+z b n2 k bc

= + z+ Kr )

2 cD c b + cn2 2b D b + cn2

2

1 k 1 n2 m2 m (k=D z)

Eust

i = z + +

2 D c b 2c c

K m b + cn2 k z 2

bc

qG G qR R + ny + :

nD c b cD c 2 (b + cn2 )

R R = + +

Dbc (b + c) bc (b + c) b cD c

k (n 1)2 qR K

= 1 > 0:

D (b + c) nk

k z b + nc k n 1 qR K Rno Rst

Gno EGst = 1 = 1 = > 0:

cD c b+c D b+c nk n 1

!

2 2

1 k 1 n2 1 1 b + nc k zD b + nc

Eust

i Euno

i = z + + +m 1

2 D c b c b b+c cD b+c

!

K k (b + nc)2 b + cn2 2

bc b+c 1

z +

Dn D bc (b + c) bc 2 (b + cn)2 b + cn2

!

bc2

(k=D z)2 K k

= 2 + z

2 (b + nc) (b + cn2 ) 2bc (b + c) Dnbc (b + c) D

m (k=D z)

(b + c) b + cn2 (b + nc)2 (n 1)

b+c

!

(bc [n 1])2 (k=D z) [n 1]2 k 2K m (k=D z) (n 1)

= z :

2 (b + nc)2 (b + cn2 ) 2 (b + c) D Dn (b + c)

44

Thus, we get U st > U no if

(k=D z) (n 1) k (n 1)2 qR K

Eust

i Euno

i +m z 1 =

(b + c) D (b + c) nk

" #!

2

(bc )2 [n 1]2 [n 1]2 k 2K k 2zk qR K

z z + 1 >0

2 (b + nc)2 (b + cn2 ) 2 (b + c) D Dn D D nk

" #

2 2 2

(bc )2 (b + c) K k qR 2k 2 qR 2 ( qR )2

) > + + 2

(b + nc)2 (b + cn2 ) D K n nK n n2

" #

2 2 2

K K + (n 1) x qR 2 (K + (n 1) x) 2 qR 1

= + 2

D K n nK n n2

2

K nx 2

= (n 1)2 1 + (1 qR )2 :

Dn K

0

k = (gi + Ri y i ) d + zD ) (7.16)

0 1 k zD k zD

yei y = ; Ri = 0 1 + y i gi ;

d d

k zD X

0 1

dri = + y i gi qR Ri; erj : (7.17)

d j6=i

k zD X

0 1

Ui = EC (G) kri + xrj + U (G; R) :

d j6=i

If the negotiations fail, the default outcome is the noncooperative outcome, giving every-

one the same utility. Since the ri s follow from the gi s in (7.17), everyone understands that

negotiating the gi s is equivalent to negotiating the ri s. Since all countries have identical

preferences w.r.t. the ri s (and their default utility is the same) the ri s are going to be

equal for every i. Symmetry requires that ri , and thus [gi + qR Ri; y i ], is the same

for all countries. (7.17) becomes

0 1 k zD

Dri = :

d

45

E¢ ciency requires (f.o.c. of Ui w.r.t. recognizing gi = qR Ri; + y i and @ri =@ =

1=D8i):

Combined with (7.17), neither G nor R can be functions of R (Ri in (7.17) and (7.18) are

not functions of R ). Thus, UR = qR K=Dn, just as before, and UG cannot be a function

of R (since URG = 0). (7.18) then implies that EG is a constant and, since we must have

= (EG qG G ) =n+qR R =n y, (7.17) gives @ri =@G = (@ri =@gi ) (@gi =@ ) (@ =@G ) =

qG =Dn. Hence, UG = qG K=Dn + UR qG = qG (1 qR ) K=Dn, giving a unique equi-

librium, (7.3) and (7.4), just as before. Substituted in (7.18):

This is the same pollution level as in the …rst best (3.3). But investments might be

suboptimally low. Combining (7.19) with (7.16),

0 1 k K qR K D

(gi + Ri y i ) =n EC 0 (G) m= + 1 =

n d D Dn dn

K 1 + (n 1) x=K (D en) (n 1)

K xD=K + e + qR (D=n e)

1 + qR = :

Dn 1 (n 1) e=D Dn en (n Dn 1) D= (n 1) e

0 P

Under (Q), = b (gi + Ri y i ) and EC 0 = c (qG G + i gi ), so

lt

( 0 =n EC 0 ) ( 0 =n EC 0 ) = b gilt + gi =n cn gilt gi )

K=D x=K + e=D + qR (1=n e=D)

Egi gilt = :

b + cn2 1= (n 1) + e=D

At the start of t = 1, countries negotiate emission levels for every period t 2 f1; :::; T g.

The investment level in period T is (7.17) for the same reasons as given above.

Anticipating the equilibrium Ri;T (and Rj;T ) i can invest qR less units in period T for

each invested unit in period T 1. Thus, in period T 1, i invests until:

0

k = d (gi;T 1 + Ri;T 1y i ) + qR k ) (7.20)

X

0 1

Ri;T 1 = qR Ri;T 1 + dri;T 1+ erj;T 1 = y i gi;T 1 (k (1 qR ) =d) :

j6=i

46

The same argument applies to every period T t, t 2 f1; :::T 1g, and the investment

level is given by the analogous equation for each period but T .

In equilibrium, all countries enjoy the same yi y i and default utilities. Thus, just

as before, they will negotiate the gi s such that that they will all face the same cost of

investment in equilibrium. Thus, ri = rj = r and

0 1

Dr = (y i gi qR Ri;t 1 ) (k (1 qR ) =d) :

0 1 0 1

Dr = yi gi qR y i git 1

(k (1 qR ) =d) (k (1 qR ) =d)

0 1

= y i (1 qR ) gi + qR git 1

(1 qR ) (k (1 qR ) =d) : (7.21)

Since ri = rj , (7.20) implies that the equilibrium gi;t + qR Ri;t 1 y i;t is the same (say & t )

for all is:

gi;t + qRt Ri; 1 y i = & t ; t 2 [1; T ]:

All countries have the same preferences over the & t s. Dynamic e¢ ciency requires that

the countries are not better o¤ after a change in the & t s (and thus the gi;t s), given by

( & t ; & t+1 ), such that G is unchanged after two periods, i.e., & t qG = & t+1 , t 2

[1; T 1]. From (7.21), this implies

2

nEC 0 (Gt ) & t + gt K=D + ( & t+1 gt qR ) K=D gt+1 qR K=D 08 & t )

2

EC 0 n + K=D (qG + qR ) K=D + qG dR K=D &t 08 & t )

EC 0 n + (1 qR ) (1 qG ) K=nD = 0:

Using (7.20),

0 k (1 qR ) qG (1 qR ) K

EC 0 (G) n nm = (1 qR ) (1 qG ) K=D

d D

k (1 qR ) k K K x=K + e=D

= (1 qR ) K=D = (1 qR ) = (1 qR ) :

d d D D 1= (n 1) e=D

The gi;T satis…es (7.19) for the same reasons as in the previous proof (and since they do

not in‡uence any Ri;t , t < T ). It is easy to check that UR and UG are the same as before.

47

0 e+ P 0

Under (Q), = b (y i gi Ri ), EC 0 = c EG gj , and since EcGn n UG =

0 for gi (R), we have

X

b (y i gi Ri ) nc Ge+ gj n UG

h X i k K

b (y i gi Ri ) nc Ge+ gj n UG = (1 qR ) )

d D

k K K x=K + e=D

gi gilt b + cn2 = (1 qR ) = (1 qR ) :

d D D 1= (n 1) e=D

The optimal T balances the cost of under-investment and the cost of not knowing future

s. In period T , countries invest suboptimally not only because of e and x, but because

of the hold-up problem: one more unit of Ri in period T + 1 is not worth much to i, since

the other countries will take advantage of it and pollute more. When all countries invest

less, ui declines. The loss in period T , compared to the earlier periods, is under (Q):

2 2

b k (1 qR ) b k zD K k (1 qR ) k zD

= + + (1 qR )

2 bd 2 bd D bd bd

2

qR K k 1 k=K d=D qR qR (d=D 1=n)

= 2

1 + :

bD K n d2 =D2 2 2d2 =D2

Note that H increases in e (for given D), x (for given K) and n but decreases in b.

Another cost of the long-term agreement is associated with . Although EC 0 and thus

EGt is the same for all periods,

!2 !2

c c X

t

c c X

t

t t0 t t0

E (Gt )2 = E EGt + t0 qG = (EGt )2 + E t0 qG

2 2 t0 =1

2 2 t0 =1

c c X

t

2(t t0 ) c c 1 2t

qG

= (EGt )2 + 2

qG = EG2t + 2

2

:

2 2 t0 =1

2 2 1 qG

For the T periods, the total present discounted value of this loss is L, given by:

XT

c 1 2t

qG c 2 X T

2 t 1 t 1 2t

L(T ) = 2

= 2

1 qG

t=1

2 1 qG 2 (1 qG ) t=1

T T 2T

c 2 1 2 1 qG

= 2

q G 2

) (7.22)

2 (1 qG ) 1 1 qG

T

c 2 ln 1 2T +2

qG 2

(1 + ln (qG ) = ln )

L0 (T ) = 2 2

:

2 (1 qG ) 1 1 qG

48

If all future agreements last Tb periods, the optimal T for this agreement is given by

!

X1

Tb0

min L(T ) + T 1 H + T L Tb )

T

=0

0

0 = L (T ) + T

ln H= + L Tb = L0 (T ) + T

ln H= + L Tb

2 3

c 2

1 2T +2

qG (1 + 2

ln (qG ) = ln ) H= + L Tb

= T

ln 4 5

(7.23)

2

2 (1 qG ) 1 1 2

qG Tb0

1

T

assuming some T satis…es (7.23). Since ln > 0 and the bracket-parenthesis in-

creases in T , the loss decreases in T for small T but increases for large T , and there is

a unique T minimizing the loss (even if the loss function is not necessarily globally con-

cave). Since the history (G and R ) does not enter (7.23), T satisfying (7.23) equals Tb,

assuming also Tb is optimal. Substituting Tb = T and (7.22) in (7.23) gives:

T 2T

c 2 qG2

1 qG 2T

2

ln (qG )

H= = 2 2 T

qG 1+ ; (7.24)

2 (1 qG ) (1 qG ) 1 ln

right-hand side even when T ! 1:

c 2 qG2

2 2

< H= : (7.25)

2 (1 qG ) (1 qG )

If e (for given D), x (for given K) and n are large, but b small, H is large and (7.25) is

2

more likely to hold and if it does not, the T satisfying (7.24) is larger. If c or are large,

(7.25) is less likely to hold and if it does not, (7.24) requires T to decrease.

X

Wide = gide + Ri yi e+

C G gjde + U:

1X X

Wide + Wjre Wjde kri + x rj ; (7.26)

n j j6=i

49

where Wire is the utilities after renegotiation. Maximizing the expectation of this expres-

sion w.r.t. ri gives the f.o.c.

0

k = d gide + Ri y i (1 1=n) + Dz (1 1=n) (7.27)

D X re X1

+E @ Wi =@R e 0 gjde + Rj y j + Dz :

n j6=i

n

P 0

Requiring …rst-best investments, ED (@ ( Wire ) =@R) = K, and since gide + Ri yi

must be the same for all is,

0 0 kn K

k= gide + Ri y i (d D=n) + K=n ) gide + Ri yi = : (7.28)

dn D

0 kn K K

gide + Ri yi E 0 (gi + Ri yi) = (1 qR )

dn D D

K x=K + e=D

= + qR : (7.29)

D 1=n e=D

Since yide y i is the same for every i in equilibrium, the bargaining game (when renego-

tiating the gide s) is symmetric and the renegotiated gire s become e¢ cient (just as under

short-term agreements). Since the …rst best is implemented, UR and UG are as before.

0

Under (Q), gide + Ri yi E 0 (gi + Ri y i ) = b Egi gilt , so

K x=K + e=D

Egi gide = + qR :

bD 1=n e=D

Intuitively, the reason for achieving the …rst best is not that i receives 1=n of the joint

surplus. To see this, suppose i were recognized to make a take-it-or-leave-it o¤er (with

transfers) with probability pi . The expected utility of i could be written, replacing (7.26):

X X

Wide + pi Wjre Wjde kri + x rj :

j j6=i

If pi = 1, this becomes

X X X

Wjre Wjde kri + x rj

j j6=i j6=i

P

and maximizing this w.r.t. ri is not identical to maximizing j Wjre , which would have

given the …rst best. In fact, pi = 1 leads to underinvestment from i since a larger ri

50

improves the other countries’threat point. On the other hand, pi = 0 could motivate i

to invest optimally, since the f.o.c. for the investment would be:

0

k=d gide + Ri y i + Dz;

and equilibrium investments can be arbitrarily large if just gide is su¢ ciently small. Thus,

countries may invest a lot with this renegotiation design not because they share the total

surplus but because their starting point, or threat point, Wide , is very sensitive to ri when

gide is very small.

The intuition can be strengthened by considering an example with n ! 1 and, for

simplicity, x = = 0 ) z = 0. If n ! 1, one can let the externality be positive but

…nite if this is equal to some constant E D d. By de…nition, D d = e (n 1), so

this requires that the externality per country, e = E= (n 1) goes to zero, but the total

externality is still positive. In the limit, i is simply maximizing Wide and the …rst-order

condition w.r.t. ri , (7.27), becomes:

0

k=d gide + Ri yi :

0 K E

gide + Ri yi E 0 (gi + Ri yi) = :

D D E

Intuition: In this case, each country internalizes the externality E simply by maximizing

Wide because of the large marginal utility of a better technology in the default outcome,

@Wide =@ri > @Wire =@ri . Countries are here investing as if they end up with the default

outcome, even if they receive a larger quota in equilibrium.

An alternative intuition based on transfers can be stated as follows. In equilibrium,

with the Nash Bargaining Solution, I can calculate the transfer to be ti to country i,

where: !

1 X n 1

ti = Wide Wjde .

n 1 j6=i

n

Thus, if ri changes marginally in a symmetric equilibrium, the transfer changes according

to:

@ti n 1 0

= (d e) de ,

@ri n

51

0 0

where de gjde + Rj y j 8j in the symmetric equilibrium. In general, the transfer is

not equal to the externality on the other countries. But to motivate …rst-best investments,

these transfers must equal the externality, and this can always be achieved (if d > e) since

0

de is a function of gide .

Take period 1, and assume the countries renegotiate the gi;1 s only (a similar logic holds

if they simultaneously renegotiate future emission levels). If T > 1, Ri;t for t = 2 is

given by gi;2 , nothwitstanding Ri1 and whether the renegotiation over gi;1 fails. Thus, the

equilibrium …rst-order condition w.r.t. ri1 is:

de 0

k = d gi;1 + Ri;1 y i + qR k (1 1=n)

D X re 1 X 0 de

+E @ Wi =@R e gj;1 + Rj;1 yj

n n j6=i

P 0

Requiring …rst-best investments, ED (@ ( Wire ) =@R) = K, and since de

gi;1 + Ri;1 yi

must be the same for all is,

k [1 qR (11=n)] = (d e) 0 gi;1

de

+ Ri y i (1 1=n) + K=n )

0 de k [n qR (n 1)] K

gi;1 + Ri y i = : (7.30)

dn D

Comparing (7.30) and (7.28) reveals that gide is larger in the present case. Under (Q):

K x=K + e=D qR x=Kn

Egi gide = (1 qR ) + :

Db 1=n e=D 1=n e=D

de

Similar argument holds for t > 1, but since R depends on the latest realization of , gi;t

must be renegotiated after is realized in period t 1:

e R , investments are given by EWR = k=D while they should optimally be EWR =

W G;

K=Dn, requiring K + x (n 1) = K=n ) x = K=n: Under long-term agreements, the

0

optimal Ri is given by (gi + Ri y i ) D + nzD = K;which is the same as the equilib-

0

rium d + zD = k if x = K ( qR + en (1 qR ) =D) =n: For an agreement lasting T > 1

52

0

periods, Ri;t , t < T , should be D (gi;t + Ri y i ) + qR K = K; which is the same as

the equilibrium Ri;t if K (1 qR ) =D = k (1 qR ) =d ) x = eK=D. Proposition 10

follows since x > 0 is allowed in the proofs above.

The proof of Proposition 11 is equivalent to the text following it, and thus omitted.

Proposition 12 follows since heterogeneity is allowed in the proofs above.

53

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