REGULATION AND COORDINATION OF INTERNATIONAL ENVIRONMENTAL EXTERNALITIES WITH INCOMPLETE INFORMATION AND COSTLY PUBLIC FUNDS FAYSAL MANSOURI and SLIM BEN YOUSSEF Faculté des Sciences Economiques et de Gestion de Tunis, Campus Universitaire Abstract In this article, we study cross-border externalities in a game played by two principal-agent pairs with adverse selection. Each firm0 agent is located in one country and generates pollution by pro- ducing complementary or substitute goods, sold on a common market. A fraction of pollution is transferred from one country to another. Each regulator0principal is imperfectly informed about the marginal cost of his domestic firm and accordingly uses secret incentive contracts with costly public funds. We show the necessity of cooperation between competing regulators to effectively inter- nalize all the damages caused to the environment, while reaching the first best. If the level of uncertainty is sufficiently low, we obtain an infinity of noncooperative Bayesian differentiable equi- libria, which may necessitate competing regulators to coordinate on an equilibrium. Such coordination constitutes an incentive for competing regulators to cooperate. Our major result states that under some circumstances asymmetric information relaxes the transborder externality problem. Indeed, we show that, when there is a major transfer of pollution and firms’ marginal costs are sufficiently high, competing regulators are better off under uncer- tainty. Therefore, asymmetry of information can have the very consequence of generating regulation that is too strict from the domestic viewpoint but that improves social efficiency when the benefits to both countries are taken into account. Faculté des Sciences Economiques et de Gestion de Tunis, Campus Universitaire, Avenue 7 Novembre, Tunis 1050, Tunisia ~Faysal.Mansouri@Fsegt.Rnu.Tn! . We are greatly appreciative to Jean-Jacques Laffont for his valuable insights and sugges- tions. Our thanks deeply extend to John Conley for his rich comments on earlier versions of this paper. Also, we are thankful to David Martimort, Akram Temimi, and two anonymous referees. Errors or shortcomings in this paper are the exclusive responsibility of the authors. Received 15 July 1997; Accepted 1 August 1999. © 2000 Blackwell Publishers, Inc. Journal of Public Economic Theory,2 ~3! , 2000, pp. 365–388. 365