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									       Rule of law and policy-induced environmental technology adoption

Davide Infante

Associate Professor of Political Economy

Department of Economics and Statistics, University of Calabria, 87036 Campus di

Arcavacata di Rende (Cosenza) – Italy; tel: 0039 0984 492460;

fax: 0039 0984 492421; e-mail:

Janna Smirnova

Postdoctoral Research Fellow in Political Economy

Department of Economics and Statistics, University of Calabria, 87036 Campus di

Arcavacata di Rende (Cosenza) – Italy; tel: 0039 0984 492444;

fax: 0039 0984 492421; e-mail:

Address for manuscript correspondence: Prof. Davide Infante, Department of

Economics and Statistics, University of Calabria, 87036 Campus di Arcavacata di

Rende (Cosenza) – Italy; tel: 0039 0984 492460; fax: 0039 0984 492421;


       Rule of law and policy-induced environmental technology adoption


       The implementation of environmental technologies almost always complies

with regulation that is interdependent with the strength of the rule of law. We develop

a model demonstrating that when the rule of law is reinforced, pollution abatement

standard is more efficiently established and leads to the more successful adoption of

environmentally friendly technologies. We show that a more stringent rule of law

contributes to the achievement of second best allocation with less resource drainage

caused by rent-seeking and with lower costs of regulatory intervention. The model

sheds new light on implementation of environmental policies in a reinforcing

institutional context of developing economies.

JEL classification: H11; H23; P20.

Key Words: Rule of law; Pollution; Environmental technologies; Rent-seeking

Running Title: Rule of law and environmental technology

1. Introduction

       Policy and institutional quality are highly interdependent: a strong

institutional environment is the result of successfully implemented policies, while

effective policies are grounded in high-quality institutions. Understanding the nature

of this relationship is crucial for economic development, particularly for societies

involved in significant social and economic changes, such as transition and

developing economies characterized by economic instability and a weak institutional

environment. In such contexts, institutions and policies undergo continuous changes,

which in turn influence the policy-institution equilibrium.

       To analyse the relationship between institutions and policies we have

developed a model that focuses on the rule of law since it is one of the most

important institutions determining the implementation and outcome of economic

policy. A tangible example where the quality of the rule of law plays a crucial role is

that involving the adoption of environmentally friendly technologies. In fact,

environmental issues represent an ideal context for studying the interdependence

between institutions and policies for two reasons. The first is the fact that

environmental sustainability is a real and current international concern. Secondly,

environmental controls (Lovely and Popp 2008) almost always comply with

regulation, thus providing a context to model the interaction between institution

strength and success of regulatory policy (environmental policies are reviewed by

Jaffe et al. 2002 and Requate 2005).

       While it is recognized that a complex interdependent relation exists between

the quality of institutions and the functionality of environmental policies, to our

knowledge there has been little theoretical work investigating this nexus. Our model

takes a step in this direction and examines how the stringency of the rule of law,

influences whether regulator policies are successfully implemented. In particular, we

demonstrate that reinforcing the rule of law not only increases the adoption of

environmentally friendly technologies, but also improves the implementation of

pollution abatement standards. More stringent rule of law leads to better allocation of

resources and thus increases social welfare.

2. Theoretical background

      Among other crucial institutions, that of the rule of law has been captured

through both empirical and theoretical studies (for the discussion see Haggard and

Tiede 2011). In most of the cases, the rule of law is measured through the protection

of property rights (Acemoglu and Johnson 1993, Shleifer and Vishny 1994;

Acemoglu and Verdier 1998, Grossman 2001, Gradstein 2004, Donnelly 2006). Some

authors consider the rule of law to be reflected in other contexts. For example,

Cervellati et al. (2008b) interpreted the rule of law as the presence of social contracts

that delimit the conflicts society. Donnelly (2006) gave another plausible definition of

the rule of law describing it as the legitimacy by which the state provides security for

its citizens. This vision is close to Paavola’s (2007) who underlines that legitimacy

must rest on procedural justice. Another approach considers the importance of legal

origins as the fundamentals of the rule of law (Acemoglu et al. 2001, Beck et al.

2003, Djankov et al 2003). Finally, others (Licht et al. 2007, Cervellati 2008a,

Norman 2009) have captured the rule of law using the well-known composite index

provided by Kaufmann et al. (2007) or other indexes (Butkiewicz et al. 2006).

       The above contributions underline the importance of the enforcement of the

rule of law for determining successful economic policies. Following this reasoning,

the rule of law should play a crucial role also in implementation of environmental

regulations. According to Vatn (2005 and 2010), the institutional frame is

fundamental for environmental policy, given that it influences agents behaviour

which becomes especially important in the presence of externalities typically present

in environmental issues.

       A constantly increasing body of literature has provided evidence on the

importance of institutions in environmental issues. Among empirical studies, much

attention has been dedicated to the impact of corruption on environmental issues

(Damania et al. 2003, Cole 2007, Leitão 2010). Corruption is demonstrated to have a

negative effect on environmental quality, undermining the working of environmental

policies, especially in developing economies. Institutions such as political liberties,

civil rights and democracy (Torras and Boyce 1998, Bhattarai and Hammig 2001,

Frankel and Rose 2002) are proved to contribute positively on pollution abatement.

Secure property rights are also important for improvement of environmental quality

(Culas 2007). In turn, legal protection is demonstrated to have negative relationship

with pollution levels (Di Vita 2009).

   At the theoretical level, Brock and Taylor (2003), Dinda (2004) and Yandle et al.

(2004) discuss the influence of institutions on environmental quality and demonstrate

the importance of institutional strength in pollution abatement. Weisbuch (2000)

analyses the influence of institutions in decision making process regarding

environmental issues. Paavola (2007) discusses the incidence of property rights on

the use of environmental resources. Damania et al. (2003), Fredriksson and Svensson

(2003) and Wilson and Damania (2005) demonstrate the negative effects of

corruption on the stringency of environmental policy.

       Although rule of law is one of the important institutions for environmental

policies, as discussed by Galeotti (2007), it has not been much considered. Few works

(Panayotou 1997, Bhattarai and Hammig 2001) incorporate the rule of law by

utilising composed indexes and demonstrate that institutional improvement

significantly reduce the degree of pollution.

       Our work differs from the previous studies on environment-institutions

relationship by analysing theoretically the rule of law in environmental issues through

investigating on regulator policy that promotes the adoption of environmentally

friendly technologies. The model also adds the analysis of the importance of

institutions to a growing theoretical literature on the interaction between

environmental policy and technological change (among recent works are Kerr and

Newell 2003, Goel and Hsieh 2006, Lovely and Popp 2008 and the review elaborated

by Jaffe at al. 2002).

       Our theoretical framework is related to the model presented by Acemoglu and

Verdier (2000) who explored the issue of new technology adoption in the presence of

corruption. This framework has been further developed by Infante and Smirnova

(2009) by incorporating into the model an institutional parameter to investigate on the

importance of institutional enforcement. The present work extends the above two

models to investigate the relationship between the adoption of environmentally

friendly technologies and the stringency of the rule of law. To our knowledge, to

date, no model has yet explored this relationship.

3. Model

       The model is based on stylized features of an economy in which agents can be

both entrepreneurs or inspectors. The entrepreneurs produce output with currently

available but an environmentally unfriendly technology. A regulator sets either fines

and subsidies to incentivise entrepreneurs into choosing the clean technology.

Inspectors monitor firms randomly to determine which should be subsidised or fined.

Although inspectors can be corrupt and seek bribes from a firm, there is the

possibility that the firm appeals to the court. The probability of appealing to court is

taken as a measure of the strength of the rule of law. The aim of the regulator is

therefore to implement a policy so to achieve a second-best allocation where all

entrepreneurs utilise the environmentally friendly technology, thereby neutralising


       The outcomes of the model are firstly obtained for a weak institutional

context. Thereafter, we assume that the rule of law is reinforced (section 3.5) and,

finally, revise the outcomes of the model to capture these changes.

3.1. Regulator

       In a closed economy with a command control context, the entrepreneurs (n)

produce output (y) by utilizing a production process which relies on a polluting

technology. The benevolent regulator1 makes the decision to regulate the pollution

level (), providing incentives that encourage entrepreneurs to adopt an

environmentally friendly technology of cost c, where c £ y . To do this, the regulator

employs, choosing from among the entrepreneurs, some inspectors2, who must

enforce the regulation, offering these inspectors wage w. The total number of

entrepreneurs and inspectors is normalised to 1.

  Environmental matters often involve solutions based on the central role of the
government which determines decisional rules, commands, controls and procedures
to observe when making environmental decisions (Boyer and Porrini 2001, Paavola
2007). The presence of benevolent government does not contradict the presence of
weak institutions, given that in this context the interests of the policy-maker are often
different from those who implement the policy.
  The description of allocation of agents between inspectors and entrepreneurs is not
shown for the sake of simplicity. However, an example of such a mechanism can be
found in Infante and Smirnova (2010).

       To incentivise the choice of the new technology, inspectors transfer subsidies

(s) to reward entrepreneurs who adopt the environmentally friendly technology (of

number m), and collect fines (f) to sanction entrepreneurs who continue to utilize a

polluting technology (of number n-m).

       We assume that the regulator aims to obtain the complete abatement of

emissions, which requires that all of the entrepreneurs adopt the new technology3 (in

this case it would be n=m). Indeed, for the regulator, total neutralisation of external

harm is convenient only when the benefits from the complete abatement of emissions

offset the costs needed for abatement. Therefore, the regulator incentivises the

adoption of the environmentally friendly technology only in the case where

intervention increases social welfare. In other words, the decision to regulate is taken

only when the welfare level attainable through intervention is greater than that

without intervention. That is, W 2 ³ W1where:

W1 = y - a                                                                 (1)

W2 = (y - c)n                                                              (2)

   Inducing a radical change in technology is a reasonable assumption since
incremental technology change may not achieve environmental sustainability (Kemp

3.2. Entrepreneurs and inspectors

          Since the adoption of the environmentally friendly technology is costly,

entrepreneurs adopt it only in the presence of regulatory stimuli. These stimuli are

expressed as environmental subsidies and fines. Both subsidies and fines are activated

only when monitoring is undertaken by the inspector, so that, subsidies and fines are

paid and obtained with a probability 1- n , and hence 0.5 £ n £1. Following

Acemoglu and Verdier (2000) this also means that an inspector can monitor only one

entrepreneur. To avoid the regulator supporting the entire social cost of pollution

abatement, it is assumed that subsidies are rationed, i.e. that not all of the adopters

receive subsidies, given that the total amount of environmental taxes should be equal

to environmental subsidies. Moreover, subsidies are taken in the form of tax offsets,

that are discounted from general revenue tax that both types of entrepreneurs pay.

The presence of general revenue tax guarantees the sustainability of regulator’s


          In such a rationed context subsidies and fines thus represent an ideal terrain

for inspectors’ rent-seeking activities (Bardhan 1997, Saha 2001). An inspector who

is self-interested would have quite a degree of freedom to practice corruption and, in

addition to the salary received as an inspector, may obtain a bribe (b), from both

entrepreneurs who do adopt the new technology and those who do not. The adopters

    This amount of taxes is omitted in the model for the sake of simplicity.

may be extorted and be asked to pay a bribe to obtain their rightful subsidy, while

non-adopters may also be asked to pay a bribe so that the inspector falsely reports use

of the new technology. Obviously, in the latter case b £ f . The probability of

practicing rent-seeking is given by r.

3.3. Rule of law

       The rule of law is inserted in the model following Donnelly (2006, p.37) who

states that, “When citizens can bring disputes concerning rights to court rather than

fight in the streets, the rule of law is enhanced”. We, therefore, define the rule of law

as the probability that an entrepreneur, who is the subject of extortion or corrupt

proposals, appeals to a court. This approach is close to that adopted by Rijckeghem

and Weder (2000), who, on the contrary, used an index of rule of law as a proxy of

the probability that corruption will be detected. Hence, we suppose that in the case

where an inspector seeks bribes, there is a certain probability (d) that the inspector is

reported. Assuming that the regulator may penalize the inspector and not the

entrepreneur for rent-seeking activities, in the event that corruption is reported by

entrepreneurs, the corrupt inspector will be fired, losing salary and other gains.

       Our model considers the rule of law reinforced when the probability of being

reported increases in the range from zero to one. Therefore, the strength of the rule of

law and the degree to which society accepts rent-seeking activities becomes decisive

in whether individuals opt for corrupt practices. Where the rule of law is weak and

rent-seeking activities offer high returns, there is greater incentive to switch to rent-

seeking activities. By contrast, where the rule of law is strong and corruption is less

practicable, the payoff that an inspector receives is greater if s/he adheres to honest


3.4. Implementing the pollution abatement policy

3.4.1. Sequence of events

       By introducing inspectors, the aim of the regulator is to achieve a second-best

equilibrium where all the entrepreneurs choose to utilize the environmentally friendly

technology to neutralise pollution and increase social welfare. To achieve this

equilibrium, the regulator utilises the following instruments: the inspectors’ wages,

and entrepreneurs’ subsidies and fines.

       The sequence of events is traced through backward induction (see Figure 1).

At the first stage, the regulator calculates the second-best allocation of agents to

obtain n=m, by considering technological, budgetary, non-bankruptcy and corruption

constraints, also taking into account the following factors: a) the cost of adopting a

new technology; b) the output of entrepreneurs; c) the probability that inspectors

practice corruption and extortion; d) the level of bribes; e) the strength of rule of law.

At the following stage, on the basis of the second-best allocation of agents, the

abatement standard of external harm, (  st ), is determined by comparing welfare

functions (1) and (2). This abatement standard or, in other words, the threshold level

of pollution, determines whether the regulator undertakes action. In fact, the regulator

decides to incentivise the adoption of the environmentally friendly technology if the

actual level of pollution is greater than the obtained abatement standard a ³ a st .

Once the decision to intervene is taken, the regulator establishes the levels of

subsidies, fines and inspectors’ wages so that the composition of these variables

would indeed lead to the allocation of agents n=m to neutralize external harm ( a =0).

This mechanism of regulator intervention is represented in Figure 1.

            Fig. 1. The pollution abatement strategy: flows and outcomes.

3.4.2. Second-best allocation and the abatement standard

       In this section we describe the steps involved for establishing the

aforementioned regulator’s policy. In order to define the second-best allocation of

entrepreneurs and inspectors, the regulator must first consider the technological


                      1- n 1- n                   1- n      1- n
y - a (n - m) - c +       s-    rb ³ y - (1- r) f      - rb      ,         (3)
                       n     n                     n         n

where on the left side there are the gains of entrepreneurs who adopt the new

technology, while on the right side there are the gains obtained by entrepreneurs who

continue to use the polluting technology.

       The first three terms of inequality (3) define the output, minus the loss (in the

form of pollution produced by entrepreneurs who continue to use the old technology),

and minus the cost of adopting the environmentally friendly technology. The latter

two terms on the left side refer to the gains obtained through subsidy which is

received, given the probability of being monitored, and losses due to a bribe, given

the probability of being monitored by a corrupt inspector. On the right side, the first

term defines the entrepreneur’s output and the second refers to losses due to the

payment of fines, if monitored by an honest inspector. The last term defines losses

due to a bribe, given the probability of being monitored by a dishonest inspector.

Obviously, the regulator establishes that the gains of entrepreneurs who adopt the

new technology are greater than of those who do not adopt it.

       At the same time, the regulator should consider that fines paid by

entrepreneurs who continue to utilize the environmentally unfriendly technology

should not exceed the output produced by these entrepreneurs, so the non-bankruptcy

constraint has the following form:

f £y                                                                       (4)

       In order to minimize rent-seeking activities, the regulator sets the gains of the

honest inspector to be greater than that of the corrupt inspector. The gains of the

honest inspector are given by the wage alone, w. The gains of the dishonest inspector

is the sum of her wage plus the benefits from receiving a bribe, minus the wage lost

given the probability that illegal actions are reported, so that:

w ³ w + rb - rdw                                                           (5)

       Finally, the regulator must also consider the sustainability of the budget, so

that the revenues of the regulator are greater than the expenditures:

1- n                                         1- n
     (1- r)(n - m) f ³ (1- n)w - rd(1- n)w +      ms                       (6)
 n                                            n

The budgetary revenues, expressed on the left, correspond to the amount of fines

collected from the entrepreneurs who do not adopt the environmentally friendly

technology, given the probability of being monitored by honest inspectors. The

budgetary expenditures, expressed on the right, corresponds to the wages paid to

inspectors, minus wages that re-enter the budget when dishonest inspectors are

reported, plus the amount of subsidies released for the adoption of the new


       The final requirement is the complete neutralization of external harm,

prompting the regulator to establish that all entrepreneurs should adopt the new

technology. i.e.:

n=m                                                                         (7)

       In order to find the second-best allocation of entrepreneurs, the regulator

solves the system of inequalities from (3) to (6). To do this, the inequality (3) is

simplified, assuming that y=f. In the next step, both sides of (3) are multiplied by m.

The obtained inequality is then summed to (6), which gives:

1- n                                                      1- n
     (1- r)(n - m)y - m(a (n - m) + c) ³ w(1- n)(1- rd) -      (1- r) my (8)
 n                                                         n

To proceed, the inequality (5) is simplified and both sides are multiplied for

(1- n)(1- rd) ³ 0. The obtained inequality is summed to (8), which gives:

1- n                                                  b 1- n
     (1- r)(n - m)y - m(a (n - m) + c) ³ (1- n)(1- rd) -     (1- r) my (9)
 n                                                    d  n

Finally, by substituting n=m in inequality (9), the second-best allocation of

entrepreneurs and inspectors is thus given by:

       d(y - yr + br) - b
mº                                                                          (10)
     d(y - yr + br) - b + dc

       As (10) demonstrates, the role of the rule of law is crucial at this stage, since,

when defining the number of entrepreneurs, the regulator must consider the

probability (d) that some entrepreneurs may report rent-seeking inspectors. In such a

case, the equilibrium of the second-best allocation of agents and, as shown hereafter,

the abatement standard, both depend on the strength of rule of law.

         Subsequently, the regulator by comparing the welfare attained in the case of

intervention (1) or in the absence of intervention (2) and, considering allocation (10),

obtains the following abatement standard:

                    d(y - yr + br) - b + dy
         a st ³ c                                                           (11)
                    d(y - yr + br) - b + dc

         As discussed in section 3.4.1, the regulator applies the pollution abatement

policy only when the actual level of pollution exceeds its pre-established threshold


         a ³ a st                                                           (12)

         Therefore, the regulator is only prompted to enact environmental-protection

policies when current levels of pollution exceed the established abatement standard

a st . In fact, the greater the value of a st , the higher the amount of actual pollution

“needed” to prompt environmental-protection intervention. At lower levels of a st the

regulator policy is enacted even for low levels of pollution, thus increasing welfare.

As such, if inequality (12) does not hold, the regulator does not enact interventions

since the benefits of pollution abatement are not large enough to offset necessary


3.5. Reinforcement of the rule of law

         The impact of the rule of law becomes evident upon differentiating (10) and

(11) with respect to the parameter d. Given that                       ³ 0, for defined parameters

value, improving the quality of rule of law would encourage entrepreneurs to report

corruption and distortion in an effort to protect their rights. As a result, under a

stringent rule of law5, more entrepreneurs would choose to adopt the environmentally

friendly technology. In fact, when the rule of law is enforced, the regulator may

subsequently need to introduce fewer inspectors, output, thus, reducing the welfare

cost of intervention. Therefore, in a context where the rule of law is functional and

strong, more entrepreneurs are willing to adopt environmentally friendly

technologies, which in turn has a positive impact on welfare, as demonstrated by

equation (2). It can also be noted from equation (10) that when the cost of the

technology decreases, the number of entrepreneurs who adopt the new technology

increases, incentivising the diffusion of the environmentally friendly technology.

         Interestingly, however, condition (11) shows that there is an inverse relation

                                                                                  ¶a st
between the strength of the rule of law and the abatement standard:                     £ 0, for the

defined parameters value. Therefore, the higher the quality of the institution, the

    Given that 1/2 £ m £1 and 0 £ d £1, the minimum of d corresponds to m=1/2 and is
           d=                                 ³0
given by        0,5(yr - c - y) + y - yr + br    ,   while the maximum is d=1.

lower the abatement standard, which indicates that, upon intervention, external harm

is neutralized more effectively. Inequality (11) also illustrates the negative effect of

illegal rent-seeking on pollution, which is high where there is room for corruption,

leading to negligible improvements in pollution abatement.

Fig. 2. Reinforcement of the rule of law and its impact on abatement standard, social

                        welfare and entrepreneurs’ allocation.

       To illustrate the above, Figure 2 shows6 the effects of different rule of law

parameter values on the allocation of entrepreneurs (m), welfare ( W 2) and the

  Coefficients used in Figure 2 and Figure 3 are normalised to one and are the
following: y=1, c=0.5, r=0.1, b=0.1, w=0.8, m=0.55.

abatement standard ( a st ). According to our findings, when the rule of law parameter

is raised, there is an increase in the number of environmental friendly technology

adopters and the level of welfare, and there is a decrease in the abatement standard of

pollution. Thus, the numerical simulations show that the reinforcement of the rule of

law positively influences the regulator policy of pollution abatement.

       The regulator instruments are considered at the last stage when level of

subsidies (s), fines (f) and wages (w) are defined. The simulation in Figure 3

evaluates these policy instruments and examines their changes obtainable under

different rule of law parameters. Both fines and subsidies (recall that subsidies take

the form of tax offset) decrease with increasingly stronger rule of law. This is

because, in the presence of weak institutions where the state cannot guarantee that all

members respect the law, more incentives are needed to prompt entrepreneurs to

switch to the environmentally friendly technology. The “carrot” in the form of

subsidies and the “stick” in the form of fines have higher values under a persistently

weak rule of law than under a situation where the rule of law is reinforced so that

agents are encouraged to take their cases to court.

       As for the relationship between the practice of rent-seeking and the strength of

the rule of law, Figure 3 shows that inspectors’ wages decrease when the probability

of being reported for corruption or extortion increases: the more likely entrepreneurs

will report illegal practices to the court, the less the amount of wage needed for an

inspector. In fact, where the quality of the rule of law is weak, more incentives are

needed to ensure that an inspector is not tempted to engage in rent-seeking activities,

making it necessary to maintain relatively high wages so to prevent corruption.

    Fig. 3. Reinforcement of the rule of law and its impact on the regulator policy.

        Equation (13), obtained by considering together (5) and (10) confirms this


                       y -a
w º y + r(b - y) + c                                                       (13)
                       c -a

where      £ 0, for the defined parameters value. There is therefore a negative

relationship between wages and the probability of being involved in corruption,

confirming empirical findings which show that higher rates of corruption are found in

countries where the wages of the public sector are low (Bardhan 1997).

4. Conclusions

       In this paper, we have developed a theoretical model that demonstrates that

the successful adoption of environmentally friendly technologies is dependent upon

the degree to which rule of law is enforced. We measure the rule of law as the

probability that entrepreneurs experiencing extortion or corruption appeal to the

court. A more stringent rule of law thus represents a tool for achieving the second-

best resources allocation when a regulator enacts an environmental policy. As such, a

strong rule of law creates barriers against losses caused by rent-seeking activities

which in the context of environmental protection, would lead to dire consequences

for the environment.

       Although the model does make some strict assumptions, our findings

contribute to a better understanding of the links between institutions and the

environment. The results of our model confirm empirical findings regarding how

conditions of the institutional context influence economic performance. In particular,

the model shows that reinforcing the rule of law actually leads to an enlargement of

the production sector opting for environmentally friendly technologies, increasing

social welfare. We also demonstrate that under a stringent rule of law, the

establishment of a pollution abatement standard is more efficient and leads to the

neutralization of even low levels of pollution. Moreover, with a reinforced rule of

law, external harm may be neutralised with lower costs of regulator intervention not

only because rent-seeking activities are discouraged, but also because fewer

inspectors are needed to enforce policies. We argue that where the rule of law is

weak, for environmentally friendly technologies to be adopted successfully, it is

necessary to redesign optimal regulator policies attainable through incentives such as

inspector wages, subsidies and fines so as to offset illegal rent-seeking activities.

       Considering both the global move towards environmental technologies plus

the fact that Countries with weak institutions, which rely heavily on polluting

technologies, are under international pressure to the same, for the effective

environmental policies it is crucial to pay more attention to the enforcement of the

rule of law. The model thus represents a contribution to encouraging transition and

developing economies to implement policies that strength the environment-

institutions relationship.


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