Politics, Public Bads, and Private Information

Preferential treatment for politically influential sectors often has undesirable consequences such as increasing pollution or ecosystem degradation. Private information on firm productivity constrains the government's ability both to redistribute income and regulate public bad production. Given political economy and information constraints, this article characterizes a social-welfare maximizing policy. The optimal policy uses a single instrument to achieve both goals, making income-support subsidies contingent upon reduction of bad outputs. Output price uncertainty works to the advantage of the government, potentially eliminating some firms' information advantage