Optimal contracts and transboundary pollution: the case of International rivers
Student name: Ms Caroline E. Abraham
Guide: Prof Badal Mukhopadhyay
Year of completion: 2012
Host Organisation: Centre for Economic Studies & Planning, Jawaharlal Nehru University, New Delhi
Supervisor (Host Organisation): Prof Krishnendu Ghosh Dastidar
Abstract: This paper attempts to model the problem of transboundary pollution in international rivers
using the framework of a Principal-Agent model. With 3 countries located in sequence along
a river, the lack of observability of countries‟ individual polluting actions (except in the
instance of the first player) introduces the problem of imperfect information. Downstream
countries being affected by the pollution of those upstream will devise contracts in order to
enjoy the gains possible from overall cooperation. The paper looks at two particular
contracting structures: In the first case, the country furthest downstream (D) attempts to
contract with both upstream agents individually in the presence of such asymmetry in
information, and in the second, I propose a contracting structure which overcomes the issue
of imperfect information by building in incentives for each downstream country to make
transfers to the country immediately upstream, or its immediate predecessor. The results
show that in the former setup, unilateral transfers from D to the upstream states fail to
achieve the cooperative outcome, to the extent that countries will actually be incentivized to
pollute more than their Nash levels in response to the offers. In the latter situation, the
cooperative outcome can be achieved provided that the parameters of the model fall within an
appropriate range. The paper also examines the feasibility of applying the concept of Perfect
Bayesian Equilibrium to the problem of transboundary pollution and finds that optimal
transfers will achieve the cooperative outcome, but the beliefs necessary to sustain such an
outcome may very likely be unrealistic.
