Modern Economy, 2011, 2, 18-24
doi:10.4236/me.2011.21003 Published Online February 2011 (http://www.SciRP.org/journal/me)
Some Notes on Modelling the Relationship between the
Environment and Institutional Context
Davide Infante, Janna Smirnova
Department of Economics and Statistics, University of Calabria, Arcavacata di Rende (Cosenza), Italy
Received January 13, 2011; revised January 23, 2011; accepted January 26, 2011
Abstract
Being a real concern of any society, environmental quality has received much attention in economic litera-
ture. However, the role that the institutional context plays in environmental issues is still an open question.
Since the environment and institutional context are closely interrelated through government regulation, the
investigation on the relationship between environment-institutions represents a fruitful terrain for economic
research. Our aim is to design research notes to study this relationship using theoretical and empirical ap-
proaches, by modelling the institutional context and estimating its impact on the environment. Our notes
could also shed fresh light on the issue of environmental policies and their implementation in emerging and
developing economies.
Keywords: Institutional Context, Environmental Polices, Pollution, Sustainable Development
1. Introduction
Issues regarding the quality of the environment represent
a real and current concern for modern society. The exis-
tence of trade-offs between economic growth and envi-
ronment, can lead conflict situations and market failures.
The achievement of an equilibrium of these trade-offs is
possible however through government regulation. The
implementation of economic po licies by the regulator, in
turn, depends on the quality of the institutional context
that exists in a given society. Therefore, the analysis of
the relationship between environmental and institutional
aspects is important to achieve the goal of sustainable
economic development.
In these notes we analyse the relationsh ip between the
environment and institutional context at theoretical and
empirical level. In particular, we aim to demonstrate how
the reinforcement of the institutional context influences
the application of environmental policies and the diffu-
sion of new technologies, and to verify the impact of
institutions on the quality of the environment and, there-
fore, on social welfare.
The impact of the institutional context on the envi-
ronment is one of the open questions in economic litera-
ture that tends to focus on specific cases and sectors and
analyses single institutions or sets. Instead, a more com-
plex analysis of institutions and their interaction with
environment may be necessary to understand the internal
processes involved and to propose variants of environ-
mental policies to increase social welfare. Two interde-
pendent reasons support th is argument. First, the applica-
tion of instruments for environmental protection rarely
occurs without state intervention and, therefore, must
comply with regulation. Second, regulation, in turn,
greatly depends on the strength of the institutional con-
text in society. These arguments make it necessary to
provide a more complete analysis of the effects of insti-
tutional context on environmental policies as well as on
evaluating its impact on environmental quality.
To reach these goals, we move in three research direc-
tions. The first considers the construction of a theo retical
model to show that environmentally friendly technology
adoption by firms is heavily dependent upon the degree
to which the rules are enforced.
The second direction of the research offers a mathe-
matical simulation of the theoretical model and illustrates
how the reinforcement of the institutional context influ-
ences the adoption of environmental technologies, the
application of environmental taxes and subsidies and the
standard of pollution abatemen t.
The third direction is dedicated to the empirical analy-
sis of the relationship between the environment–institu-
tional context and offers an econometric estimation of
two models. The first is built to study the cointegration

D. INFANTE ET AL.
19
between the institutional context, instruments for envi-
ronmental protection and economic performance. The
second econometric model analyses the impact of the
institutional context on pollution levels to estimate how
the quality of the institutional context influences emis-
sion levels and identifies its impact on th e position of the
turning point of the Environmental Kuznets Curve (EKC).
2. Critical Literature Review
A definition of the characteristics of the institutional
context that influence positively environmental protec-
tion is of great interest both in developing and developed
countries. In fact, the creation of strong institutions,
through clear legislation, financial and political stability,
defined property rights and a stable banking system, is
considered to be one of the most effective instruments of
environmental protection. Recent studies demonstrate
that the development of the institutions is a complex
process that does not follow any single rule and differs
from country to country, which creates difficulties in
defining and analysin g the institutional context.
2.1. Theoretical and Empirical Research on
Institutions
While empirical research on the effects of the institu-
tional context on economic performance is well devel-
oped, theoretical research in this field is quite limited.
The theoretical approach usually concentrates on the
analysis of a single institution or a set of institu tions and
does not consider the entire institutional context. Diffi-
culties in measuring and ambiguity in defining institu-
tions are probably responsible for this.
Public institutions are frequently analysed in models
that describe the influence of institutions on economic
performance [1,2]. A part of this research concentrates
on the effects of corruption [3] and rent-seeking [4].
These studies confirm the negative impact of legal and
illegal rent-seeking on economic performance, even
though some authors [5,6] find a positive influence,
mostly in the short term, confirming that the reinforce-
ment of the institutional context is necessary in the long
run [7].
Another type of institution analysed in the literature is
the rule of law which is fundamen tal for the implementa-
tion of environmental po licies. The rule of law is usually
measured in terms of the protection of property rights.
Among the most important studies in this field are those
of [8] and [9], which confirm the importance of property
rights protection for economic growth. Other studies
consider the rule of law to be the applicatio n of contracts
that limit conflicts in society [10], or the legiti macy with
which the regulator provides security for citizens [11].
Finally, the rule of law is considered by [12] and [13] to
be the foundation of a society’s legal origins. Although
there are many studies dedicated to the rule of law, to the
best of our knowledge, there is no work that analyses this
institution specifically in terms of the environment.
Undoubtedly, the above models make an important
contribution towards exploring the links between institu-
tions and economic performance, but they represent only
a partial analysis of the institutional context. An excep-
tion is the [14] model of organisational choice that de-
scribes the entire institutional context by utilising a pa-
rameter that reflects institutions in general, given that it
refers to corruption, the legal system, economic stability
and other factors simultaneously. Following [15], who
introduce the parameter as measure of institutional
strength, we take the [14] approach as a point of depar-
ture for institutional modelling.
As for empirical research, various models have been
developed to analyse the impact of institutions on eco-
nomic performance. It is important to stress that the
complex nature and behaviour of institutions leads to
wide divergences from one author to the next. The vari-
ables that reflect the institutional context are often based
on indices, evaluation by experts and ratings. Therefore,
empirical analysis often results in a correlation between
independent variables, rendering the models less robust.
Among the studies in this field, the institutions that are
usually analysed are property rights [9], legal origins
[16], cultural aspects [17] and economic stability [18]. A
large number of models study the impact of the rule of
law, property rights protection and corruption [19-22] on
economic growth. Yet, there is no model that aims to test
the effects of a wide range of institutions in order to ob-
tain a picture of the broader institutional context.
2.2. Research on Environment and Institutional
Context
The analysis of the links between the environment and
the institutional context is still largely unexplored, par-
ticularly at the theoretical level. This is due to the diffi-
culties in introducing an institutional context into theo-
retical models, given that current literature does not
clearly define what the institutional context is or how it
is measured. Empirical models that aim to demonstrate
results achieved at a theoretical level encounter other
difficulties. While generally there is no problem collect-
ing data on institutions, there is a problem with the
availability of data about environmental policies and
instruments of environmental protection at international
level. In fact, most empirical studies concentrate on data
in specific sectors. As a consequence, the models that

D. INFANTE ET AL.
20
study links between the environment and institutions
have problems covering both theoretical and empirical
approaches and do not fully capture the relationship be-
tween the institutional context and the environment.
Among the studies of interest is that of [23], which
presents a study on the interdependence of economic
openness, income and pollution, estimating cross-country
data, to verify the cointegration of these three variables
and their endogeneity. The first model of the empirical
part of the present research applies a similar approach
but unlike from [23], focus on the links between the in-
stitutional context, economic performance and the appli-
cation of instruments for environmental protection, by
applying co-integration analysis for panel data.
Also crucial to the present research is the [24] model
dedicated to the analysis of government policy in the
adoption of environmental technology. This model
evaluates the influence of economic openness on the
adoption of environmental technologies in the coal in-
dustry. A similar model is that of [25], who demonstrate
that the instruments for environmental protection can be
more efficient in presence of more flexible state policies,
taking the oil industry as an example. Other studies ana-
lyse the diffusion of new environmental technologies and
the level of pollution in relation to persisting rent-s eeki ng
activities and the corruption of economic agents [25,5].
Another branch of studies analyses the participation in
international environments treaties [27,28]. These studies
are also dedicated to the environment – institutions rela-
tionship but consid er only single institutions and specific
environmental issues. The second empirical model of the
present research aims to involve more institutions to
evaluate their impact on the quality of environment and
on the level of pollu tion at a global level.
In sum, currently there are no studies that fully capture
both the theoretical and the empirical levels of the rela-
tionship between the environment and the institutional
context. The present research aims to address this lacuna,
and builds a theoretical model that captures the institu-
tional context, analysing it with respect to the environ-
mental aspects and estimating their relationship at inter-
national level.
3. Theoretical and Empirical Modeling
The construction of a theoretical model aims to formalise
the interaction between the state and the production sec-
tor in the process of adoption of new environmental
technologies at a microeconomic level, taking into con-
sideration the institutional context. The model is repre-
sented in the form of a static game with imperfect infor-
mation, created using the backward induction technique
and offering a ‘second-best’ solution due to the presence
of market failures. In particular, the model describes an
economy in which firms use polluting technology, trans-
ferring a disutility to all economic agents. The regulator,
whose role is to improve social welfare, provides incen-
tives to firms to apply environmental technologies by
offering subsidies to those firms that change the type of
technology they use and imposing taxes on those who
continue to utilise the old technology. To verify the
choice of technology, the regulator employs inspectors
who monitor the firms. The inspectors transfer the funds
from state to production sector and vice versa.
It is assumed that the information is incomplete on
three levels. The first is an uncertainty regarding the
honesty of the inspector. The second is the uncertainty
connected to the monitoring of the firms, a casual proc-
ess. The last level con cern s the quality o f the in stitu tion al
context, cap tured by th e interactio n between th e firm and
the dishonest inspector. The parameters of the institu-
tional context are defined as a relationship between the
administrative capacity of the regulator and the degree of
weakness of the institutions (for ex ample, the presence of
corruption, undefined property rights, a weak legal sys-
tem, and rule of law). The value of the coefficients is
uncertain.
The role of the regulator is to achieve the adoption of
environmentally-friendly technologies, respecting the
constraints of budget, rent-seeking and technology. The
regulator intervenes in the production sector only if in-
tervention leads to an increase in social welfare. If the
regulator does not intervene, the market for environ-
mental technology fails.
In the case of state intervention, the second-best solu-
tion is influenced by the quality of the institutional con-
text that determines the allocation of economic agents,
the level of social welfare and the standard of pollution
abatement. The model shows that the reinforcement of
the institutional context limits the use of polluting tech-
nologies at a lower cost to the regulator and with fewer
inspectors. In the case of a strong institutional context,
even low pollution levels can b e neutralised by interven-
tion of the regulator.
The mathematical simulation of the model is produced
to investigate how the results can change if institutional
parameters are modified. Thus we simulate a scenario in
which the regulator can respond to the reinforcement of
the institutional context by using taxes, subsidies and
efficiency wages. In this way, the simulation allows the
possible environmental policies to be evaluated under
different institutional conditions.
The empirical model is focused on exploring the links
between the environment and the institutional context,
verifying the results obtained through the theoretical ap-
proach. The model aims to measure the correlation be-

D. INFANTE ET AL.
21
tween the institutional context, the application of instru-
ments of environmental protection and economic per-
formance in low and high income countries. The com-
parative analysis of the results from different groups of
countries is important, given that the groups differ in
their institutional contexts.
It is often maintained that an increase in income in a
country that is given to the reinforcement of the institu-
tional context implies an increase in the demand for en-
vironmental protection, and therefore, for the adoption of
environmentally-friendly technologies. Therefore, the
reinforcement of the institutional context can create the
win–win situation in the sense that it improves both the
application of environmental protection instruments and
the level of income of the country. Alternately, if the
reinforcement of the institutional context does not coin-
cide with an increase in income, environmental protec-
tion instruments are more difficult to apply.
In considering the instruments applied for environ-
mental protection, we can refer to the Environmental
Kuznets Curve (EKC), a concept, that emerged in the
early 1990s with [29] seminal paper, positing that envi-
ronmental degradation first increases and then falls with
increasing per capita income. This mechanism can be
similar to that of the application of instruments for envi-
ronmental protection, assuming that with the increase in
income the application of these instruments first goes up
and, once it has reached the turning point, goes down,
probably due to the reinforcement of the institutional
context.
In order to illustrate the links between the institution al
context, instruments for environmental protection and
income, we take into consideration the institution of the
rule of law and define income ( Y) as a function of the
rule of law (RoL ) and of other exogenous variables
(1
Z
):

1
,YfRoLZ (1)
The instruments for environmental protection (E) are
defined as a function of income (Y) and production
technology (2
Z
):

2
,EfYZ (2)
By substituting Equation (1) in (2) the following
model is obtained:

12
,,EgRoLZZ (3)
This relationship is estimated by applying the vector
autoregression model (VAR) that is considered to be
suitable for the study of endogeneity and casual mecha-
nism problems. In this model, the VAR approach can
determine the dynamic effects of the variables and test
their endogeneity in the long run.
Given the lack of observations regarding application
of the instruments for environmental protection the
analysis requires the construction of panel data. The data
related to this variable were revealed only recently. The
sole source of this data, to the best of our knowledge, is
provided by Eurostat, which keeps statistics for five dif-
ferent kinds of environmental taxes from 1996 through
2008. Data related to the income of European and other
world countries are provided by the World Bank. The
rule of law index is provided by [30] and covers a wide
range of measures, such as contract enforcement for 168
countries. The available data, however, is not complete,
and requires the addition of certain variab les through the
application of auxiliary regressions.
The second empirical model is dedicated to the com-
parative analysis of the impact of the quality of institu-
tional context on pollution levels in developing countries
(including transition economies) and developed countries.
This analysis is necessary because former socialist coun-
tries are defined by a persistent weak institutional con-
text that favours rent-seeking activities that has a nega-
tive effect on the environment.
Some indicators on the institutional context are pro-
vided by the European Bank of Reconstruction and De-
velopment for the economies of Central Europe and the
former Soviet Union. The indicators are based on four
important factors: entrepreneurs and families, markets,
financial institutions and the legal system. Based on
these factors, ten international classifications of institu-
tional context were created. As for environmental pollu-
tion, the World Bank provides data on various types of
emissions among which that of carbon dioxide is the
most widespread and frequently used.
The following linear model is estimated for pan el data
obtained for the analysis:
11
ln nm
itjjitk kitit
jk
Polx y





 (4)
where Pol is a dependent variable of environmental
pollution in country i at time t,
j
it
x
are the sets of
indicators of institutional context that influence pollu tion
levels, andkit y are country specific variables.
The existence of links between the institutional con-
text, income and pollu tion are confirmed by the analyses
of the first and the second empirical models. This result
allows us to understand how the reinforcement of the
institutional context influences the position of the EKC
turning point in different groups of countries. A number
of studies [31] demonstrate that some developed coun-
tries with high levels of income have already reached the
turning poin t of pollution on the EKC and, therefore, the
maximum level of application of environmental protec-
tion instruments. This may be due to the reinforcement

D. INFANTE ET AL.
22
of the institutional context that, as demonstrated by the
theoretical model, implies lesser costs to improve the
quality of environment.
4. Preliminary Results
The elaboration of the above models provides some im-
portant insights on the study of the relationship between
institutional context and environment. Preliminary re-
sults of the theoretical model demonstrate that institu-
tional enforcement has a significant influence on the de-
cisions of a regulator to undertake environmental policy.
Stringent institutions promote environmental policy ap-
plication, leading to improvements of pollution abate-
ment standard and of the quality of environmental pro-
tection. We also demonstrate that under a stringent rule
of law, the establishment of a pollution abatement stan-
dard is more efficient and leads to the neutralization of
even low levels of pollution. Moreover, with a reinforced
rule of law, external h arm 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.
The preliminary findings of the theoretical model are
confirmed by empirical estimations of the two econo-
metric models developed, as an example, for Western
and Central European countries. Preliminary results of
the econometric first model confirm the presence of
cointegrated relationship between environmental protec-
tion, expressed by environmental taxes [32], rule of law
index [30] and income per capita [33]. Rule of law is
taken into consideration given that it plays an important
role in environmental policies, reflecting the quality of
institutional contex t. The second empirical model further
explores the above relationship, referring to the Envi-
ronmental Kuznets Curve (see among recent studies
[34-37]), investigating on income-pollution path. For the
sample of European countries we find the evidence for
EKC for carbon emissions [32]. Moreover, for the same
data we test a similar to EKC relationship between envi-
ronmental protection and income, where the amount of
taxes paid for environmental protection first increases
and then declines beyond a certain level of per capita
income (turning point). Our results show that the behav-
ior of the curve, and the position of the turning point,
depend significantly on the stringency of institutions. In
the case of strong rule of law, the turning point of the
EKC occurs at a lower level of income per capita, thus,
decreasing emissions.
5. Conclusions
These research notes have allowed us to investigate the
relationship between the environment and institutional
context, an issue of great importance for any contempo-
rary society that aims to undertake sustainable economic
development. Despite its importance, the economic lit-
erature does not dedicate much attention to the relation-
ship between the environment-institutional context; this
is mostly due to the problems related to the difficulties in
introducing institutions in theoretical models and in ob-
taining environmental protection data for empirical esti-
mations. Our work aims to overcome these lacunae and
offers a way to formally build up the institutional con text
at theoretical level and to empirically esti mate its impact
on the environment.
The designed theoretical model based on microeco-
nomic factors captures the interaction between the state
and the productive sector during the process of institu-
tional transformation. The model is expected to demon-
strate that institutional reinforcement implies a more
stringent adoption of environmental technologies, de-
creasing their costs and increasing social welfare, and
leads to more efficient pollution abatement standards.
Reinforced institutions decrease the cost of environ-
mental policy implementation and limit the draining of
public resources by rent-seekers.
The first empirical model is expected to demonstrate
the existence of a long-term equilibrium between the rule
of law and the application of instruments for environ-
mental protection in developed and developing countries.
A strengthening of the rule of law leads to a win–win
situation, in which the application of instruments for en-
vironmental protection becomes more effective together
with improved economic performance of the country.
The second empirical model is expected to find the
extent to which different components of the institutional
context influence environmental degradation in different
groups of countries, investigating which institutions have
crucial importance on env ironmental quality. This model
checks for the dependence of the position of the turning
point of EKC on the strength of the institutional context
in different groups of countries.
By investigating the links between environment and
institutional context on both theoretical and empirical
levels, our research could also shed new light on the is-
sue of environmental policies and their implementation
in emerging and developing countries.
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