Learning about compliance under asymmetric information

Over time, inspection agencies gather information about firms’ pollution levels and this information may allow agencies to differentiate their monitoring strategies in the future. If a firm is less successful than its peers in reducing emissions, it faces the risk of being targeted for increased inspections in the next period. This risk of stricter monitoring might induce high-abatement cost firms to mimic low-abatement cost firms by choosing lower emission levels, while the latter might try to avoid being mimicked. We explain firms’ compliance decisions and the inspection agency's monitoring strategy by means of a signaling game which incorporates dynamic enforcement and learning. Interestingly, we show that the ongoing signaling game between firm types might lead to firms over-complying with the emission standard.

► Firms’ environmental compliance status can be affected by that of other firms.
► Interaction between relative emission levels and future inspections leads firms to overcomply.
► An agency is able to induce each specific type of equilibrium by adapting its inspection strategy.
► The risk of stricter monitoring might induce high-abatement cost firms to mimic low cost firms.